Integrating the Total Cost of Ownership and the Should Cost Model
Date November, 2010
Draft version 1
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Costs have always been one of the main elements with respect to purchasing. Purchasing was seen as a support function, but last decennia the focus of purchasing is shifting from cost to value: purchasing is becoming a value adding activity. It is part of the core-processes of an organization which is indicated by the fact that purchasing functions are more and more reporting to the CEO (Capgemini Consulting, Global CPO Survey, 2010).
Among others, this shift has been a result of the focus on value. The service or product delivered by an organization is highly dependent on the input (material and services) which are purchased by the procurement function. This means that delivering value to your customers starts at purchasing the right input. In order to add value for the end customer, the procurement function needs to know what the customer desires are. It seems therefore a logical consequence that purchasing need to be incorporated in the core processes of the organization.
Undoubtedly, this focus on value has brought good things and it is expected to bring even more good or even better things. Nevertheless, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources; there always exists an ultimate price which a customer can or is prepared to pay for a product or service. Conversely, costs can also be seen as a type of value for a customer. Anyhow, costs and value are dissoluble linked; generally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
Being enthusiast about the focus on value myself, I’m convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing.
In this perspective I divide cost into two categories, first cost incurred at your supplier, which is reflected in the price and secondly cost at your own organization.
The last category of costs, can be contemplated with the Total Cost of Ownership (TCO) perspective. This is not a new phenomenon anymore as we can see that supplier selection is bit by bit shifting from price-based towards TCO-based. But do managers exactly know what TCO is? And even more important, do they know how to use it? Although it is sometimes used as a fancy word by management, it sure isn’t just a hollow concept.
The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It extracts the cost-elements occurring when purchasing from a specific supplier. The price is mostly one of the main cost elements appearing from the TCO. It is good to have the wider TCO perspective when selecting a supplier, but as the price of a product or service causes a great deal of the total costs, it remains very important. Therefore price is a cost element which should obtain a solid level of attention. It is important to look whether the price is fair/right. Is the supplier efficient enough? Does it have a fair margin on it? To go beyond the old fashioned negotiation game between buyer and supplier on the price of a product or service, it may be useful to make a cost break down of your supplier’s quotation. A ‘should cost model’ may be useful here. Dependent on the willingness of the supplier and the purpose of the buyer, the ‘should cost model’ can vary from a more cooperative to an adversarial variant. The should cost model can also be used for contemplating other cost elements than price. In the remainder of this article the basics of TCO and SCM are highlighted, followed by an integration of these models, offering a new cost-perspective on purchasing.
2 Total Cost of Ownership
The Total Cost of Ownership considers ‘all’ costs involved with purchasing a product or service from a particular supplier. TCO goes beyond just the price and takes a ‘bigger picture perspective’, considering all cost of purchasing from a specific supplier over the life time of the product or service. Examples of those cost are costs with respect to quality, ordering costs, inspection costs, warehousing costs and elimination costs.
A TCO model, is a tool with which these types of costs can be determined on a structured way. In figure 1 a TCO model is depicted, below is explained how to use it.
On the horizontal axis, you can find a chronically depiction of the stages of a life cycle of a product or service. In these categories you write down the cost elements of a particular product or service during those stages. Bear in mind that those stages may vary per product, organization, industry, etcetera.
3) Unit-level: these costs are incurred on a ‘per unit basis’, and often occur in the utilization and elimination stages. They might for example be caused by inventory costs or a production shutdown caused by a defect product of the supplier.
The template given in figure 1 is a useful tool for drawing up the TCO of a product or service. Below is described how to make use of the model in order to estimate the TCO.
Senior management approval or involvement in the TCO process may make data-gathering easier.
Data-gathering is a time-consuming process, therefore it can be useful to delineate some things in step 1 and 2. For example, by conducting interviews and facilitating workshops with content-experts you can determine what the expected main cost drivers of the product or service probably are. Then you can focus on these cost elements instead of wasting valuable time on gathering data and quantifying cost elements which have a minor and less important share in the TCO price.
How to use the TCO outcome
Having calculated the TCO of a product or service, it can be used for (at least) two things. First it can be used for supplier and product selection. Compare the TCO of a product of Supplier A with the TCO of a (comparable or alternative) product of Supplier A or another supplier B. Choose the best alternative (while taking contextual qualitative aspects like market situation and the importance of the product/service into account). For example ordering products in China may be cheaper, but the transport costs may increase. What about the quality of the products? And what about the costs of the decreased flexibility. Or is chosen for a larger inventory for keeping the lead-time and flexibility at the same level? These are just a few of the many things which can (or must) be taken into account.
Secondly, the TCO value can be used to search for improvements or cost reduction. Identify the main cost drivers and look whether you and/or your supplier is able to influence those costs. Ask yourself whether the time and effort required to realize the cost reduction are larger than the cost reduction itself.
External purchases of products and services account generally for more than 60% of the total costs of an organization. Reducing the purchase price of products drives down an organization’s expenses. Should cost modeling is a valuable tool for determining a supplier's costs, whether those cost are reasonable (for the supplier as well as for your organization) and the model provides insight where in the (production) process and value chain of your supplier cost reductions are possible. A reduction at your supplier may be beneficial for both the supplier and the purchasing organization.
Instead of taking a marketing based view on purchasing by focusing purely on the lowest price, a should cost model focuses on the structure of the price. Should cost modeling is the process of determining what a product should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins (see table 1).
Bill of material (BOM)
Labour required to convert direct material into a finished product (production workers wages)
Indirect costs associated with the conversion process (depreciation, other plant costs, supervision, R&D, support, etc.)
Cost of goods sold
Sub-total (DM + DL + MOH)
General, Selling and Administration cost (GSA)
Costs included to keep the organization in operation (R&D, Finance, Procurement, marketing)
Profit before tax
Profit before taxes are subtracted
Total of all cost elements
When properly used, a should cost model is a tool which is able to provide insight in the costs and the value adding activities of your supplier. It is the tool which can be used to open up the black box of the supplier. Knowing what the cost elements and their cost drivers are, is the first necessary step in reducing the costs, because if you do not know where the costs origin from, how could you ever been able to control them? And bear in mind that controlling your costs can be a source of competitive advantage!
You need to know which cost elements are present and what the cost drivers of those cost elements are at the supplier’s processes and wherefore those costs are made and if they are necessary or just waste of resources. You have to think of aspects like:
Although SCM was originally developed for contemplating the price of a product or service, the methods used for analysing the price, can also be used for other cost elements. The other cost elements exists of processes, products, services from internal or external suppliers and will also consists of (a selection of) direct material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins. It depends whether it is a product or service (services often don’t need direct material) and whether it is from internal or external suppliers (the profit margin may not be present with internal suppliers).
4 TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?
Note that step A, B and C correspond with the steps A, B and C in figure 2.
Without taking notion of the other party in a Buyer-Supplier (B-S) dyad, cost reductions in one organization, may increase costs at the other organization. Conversely, when aligning processes, costs at one organization may increase, but the overall costs of the B-S dyad may reduce. If the buyer and supplier communicate in the last example, an organization may be prepared to increase their costs if it shares in the additional revenues at the other party (or in other words get compensated for their investments and efforts). Agreements about the division of the costs and revenues in order to reduce costs or increase revenues of a buyer-supplier dyad, is important, especially when looking to the future of the relationship.
5 What next?
Having made the first steps for recapturing the cost perspective, much work is still required in the area of procurement. With respect to this cost perspective, publications on my account are expected about Should Cost Modeling (the SCM-philosophy, practical examples, a manual, how to use a SCM outcome) and about Total Cost of Ownership. Compared to SCM more literature on TCO exists and therefore the focus will be more on SCM. Then the interaction among SCM and TCO is elaborated on, and a practical model is expected how to use this perspective in practice.
6 ReferencesMonczka, R.M., Trent, R.J., & Handfield, R.B. (2005). Purchasing & Supply Chain Management. 3rd edition. Ohio , USA: Thomson-southwestern. Cousins, P., Lamming, R., Lawson, B., & Squire, B. (2008). Strategic supply management: Principles, theories and practice. Edinburgh Gate, England: Pearson Education Limited.