I interviewed Vladislav Mandryka who discussed Total Cost of Ownership?
Hi Dustin, thanks for the opportunity of sharing my thoughts about total cost of ownership.
Hopefully this information will be useful and valuable for procurement professionals around the world.
My name is Vladislav Mandryka. I am procure to pay manager in AnadoluEfes Group with 10-years’ experience in procurement and various skills in strategic sourcing, SRM, project management, supplier performance evaluation. So recently, I have been thinking about TCO concept and particular systematic implementation of this approach. Moreover, I extracted some outcomes that could help to formulate how realize it gradually.
What does TCO mean?
TCO is a process for knowing all the important supply chain-related costs of doing business with a supplier for services and goods. TCO can improve decision making by helping managers select options that have the best overall cost impact on the organization rather than just providing a lower purchase price. In its broadest sense, TCO looks at the big picture by considering many costs beyond price.When purchasing an item or service, hidden costs may include administrative costs, usage and disposal costs, and elements of the purchase price itself. For example, hidden costs in offshoring include longer lead times, supplier distance, and unforeseen costs. Longer lead times can result due to a supplier being thousands of miles away, which increases the average lead-time and possibly the variation in that lead-time. This can drive up inventory holding costs and safety stock requirements. Distant suppliers, especially when located in different cultures, require more administrative effort to maintain relationships, and the transactions are more complex due to international documentation regulations, as well as currency exchange. Accounting for that type of overhead is part of TCO.
In addition, many other related unforeseen costs exist that do not occur with domestic purchases, including import duties, taxes, employing customs house brokers and freight forwarders, insurance coverage, and so on.
Structure of TCO
Based on my experience I would like to mention that TCO analysis should include 5 steps:
- - prepare for analysis,
- - map the process,
- - identify relevant costs,
- - gather data,
- - perform analysis.
Prepare for Analysis
The first phase of TCO is to prepare for analysis by determining if your potential purchase, process, or outsourcing decision being analyzed has a sufficiently high potential to justify the performance of TCO analysis. Here, you want to make some determination that the savings or improvement opportunity is significant, and if so, then you will need to consider assembling a team to do the analysis.
This determination will be only a rough approximation, and a quick review is usually all that will be required to see if there are significant, hidden costs that you will be able to affect. Costs can be considered hidden when they may be combined within a general category such as overhead or perhaps mixed with some other cost factors. One example could be disposal costs where a single trash receptacle removal may apply to several departments or operations, with little understanding of the origins of the waste generated.
Once you have a project in mind, you will need to assemble a team representing multiple functions potentially impacted, which could include purchasing, finance or accounting, and operations. The value of the team is to gain wide buy-in across the organization, allow for multiple perspectives, and provide access to cost information that might reside in different accounts and departments.
Map the Process
To map the process you create a diagram that shows the flow of activities involved with the acquisition, use, and ultimate disposal of the good or service that you are buying or the process change that you are considering. Like a road map, the process map is a picture that the team can use to develop an understanding where there may be areas of redundancy or inefficiency—in other words, where the areas are that can potentially be improved.
The process map allows the team to depict a complex flow in a more simple and easy-to-explain manner where relationships between activities become obvious. Anyone familiar with the process will be more able to determine if a step has been omitted.
Identify Relevant Costs
Not all costs are going to be relevant to your TCO project, so it is important to find those that will potentially make a difference to your decision-making process. It is not realistic to include every possible cost. Not only would this be overwhelming, but it is possible that you would quickly find that the cost of the analysis would outweigh its potential benefit. However, you would not want to omit significant costs because it would adversely affect the project’s outcome, which would then hurt the credibility of the analysis. The ability to determine relevant costs is a matter of informed judgment—all the more reason why a cross-functional team is beneficial.
There are several key questions that may prove helpful in identifying the relevant costs of your project:
• Are you trying to understand the true cost of an item over its entire useful life?
• Are you trying to compare various alternatives, such as two different manufacturing processes?
• Are you looking for alternatives for improvement? One of the most common decisions of this type is the make-or-buy decision, which is also called the outsourcing decision.
A powerful approach for identifying relevant costs is to divide them into categories such as usage, price, and administrative, which may also leverage your team’s expertise from such areas as operations, purchasing, and finance and accounting. As you approach the end of this phase, your key output will be a list of the data that the team will need to gather.
The gather data phase builds on the previous phases of the TCO process and addresses several key questions, including how the data-gathering effort needs to be divided between team members, where data can be collected from, how accurate the data is, and what the team needs to do should no data be available.
Another value of having a cross-functional team is that each member will likely have a good idea of where to go to get the data that their own functional area has. There will be challenges because data collection often involves a manual effort that could include sifting through old records, talking with numerous people, and observing actual processes.
Not all necessary data may be readily available, and in some cases that which is available may not be considered sufficiently accurate. These are legitimate concerns, and there may be circumstances where the team will need to make informed assumptions and estimates. Data collection needs to be an orderly process where sources are documented in the event that the team needs to return for further details at some future point.
Performing the analysis consists of taking collected data and subjecting it to various processes to convert it into meaningful information for subsequent decision making and management action.
Perform analysis is the last phase of a TCO analysis and involves three major steps: determine the unit of analysis, perform a sensitivity analysis, and present the analysis.
This phase often begins by determining the unit of analysis that represents the most meaningful way to present the TCO data to the organization. As the team proceeds with the analysis, it may need to gather more data or reevaluate the relevance of certain data.
Most TCO analysis is done on a project-by-project basis. A standard template for TCO analysis does not exist, because each analysis is different. However, if the organization completed a similar analysis in the past, it would be useful to review it for lessons learned and to verify whether the team has missed any major cost drivers.
How define the unit of analysis
It is critical to communicate your TCO results in a way that makes sense to the organization. You must answer questions such as:
• How does a company analyze and understand the cost of various purchases?
• Does a company consider annual expenditures as a key performance indicator?
• Is it by piece price or some other performance measure?
Four ways exist for examining the costs for a particular project: capital, office or manufacturing equipment, manufacturing components or consumables, and services.
To determine the unit of analysis for capital, use the total cost per relevant unit of output. To calculate this, determine the TCO for a specific period, such as the life of a product or a year, and divide it by the volume you plan to use in that same period.
For example, to determine the TCO for a car, use the cost per mile or kilometer based on how you drive. Assume the present value of total ownership is $29,000 over a five-year period, including trade-in value. You plan to drive the car 85,000 miles, or 137,000 kilometers, during that time. Therefore, the relevant total cost of ownership is:
$29,000/85,000 miles = $.0341 per mile.
Office or Manufacturing Equipment
To determine the unit of analysis for office or manufacturing equipment, use the total cost per relevant manufacturing volume. To calculate this, determine the discounted TCO for a specific period and divide it by the volume manufacturing plans to produce for that same period.
For example, with a digital copier-printer, use the actual (not potential) number of images you plan to print or copy as the volume. Assume the present value of the copier-printer, including maintenance, supplies, and all other relevant items, is $500,000. You plan to use the copier for three years and create 200,000 images during that time. Therefore, the relevant TCO is:
$500,000/200,000 images = $2.50 per image.
Manufacturing Components or Consumables
To determine the unit of analysis for manufacturing components or consumables, use the total cost per usable units purchased. To calculate this, determine the TCO for a specific period and divide it by the number of units purchased during that same period.
For example, add the TCO of all purchases for particular parts―including prices, delivery, return costs, travel expenses, holding costs, and so on―and divide by the volume purchased during that time. Assume that a firm purchased 50,000 integrated circuits (ICs) at a price of $800,000. It paid a total of $2,800, which included shipping insurance, warehouse storage until used, and testing by an outside firm. Ten of the ICs are discovered to be damaged and unusable at about the same time the firm pays for them. Therefore, the relevant cost of ownership is:
$802,800/49,990 ICs = $16.06 per IC.
To determine the unit of analysis for services, use the total cost to have the services satisfactorily performed. This may mean that cost per hour is not relevant unless a task takes everyone the same number of hours to perform. To calculate this, determine the total relevant cost and divide it by output, not input.
If you have an hourly cost, multiply it by the number of hours over the specific time you are analyzing.
For example, the relevant cost for cleaning an office building is the total cost to clean per time cleaned, or per week, month, or year. Do not use the hourly rate paid if the company bills by the hour because one supplier may charge $28 per hour while another charges $32 per hour, but the latter takes significantly fewer hours to perform the same task.
Assume a company received a quote for cleaning its processing plant 250 times a year. The quote is $30 per hour including all supplies, and it will require 20 person hours each day. Therefore, the relevant TCO for one year is:
$30 per hour × 20 hours per day × 250 days = $150,000.
About Vladislav Mandryka
Senior Procurement Specialist at Anadolu Efes, MBA