Integrating the Total Cost of Ownership and the Should Cost Model
Summary of Draft version 1
Date November, 2010
The focus on value in procurement is increasing. In order to add value for the end customer, the procurement function needs to know what the customer desires are. But as value is indissoluble linked to costs, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources. Generally speaking, differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Therefore solely focusing on value may increase costs too high for the (end)customer. This means that a trade-off must be made here, implying that costs and value must both be taken into account. Being enthusiast about the focus on value myself, I’m still convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing, as a sort of counterweight to the upcoming focus on value.
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.
The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It takes a ‘bigger picture perspective’ and extracts the cost-elements occurring when purchasing from a specific supplier over the lifetime of the product or service. The outcome of the TCO calculation can be used for supplier selection or serve as a base for cost reduction. 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. Besides price, the should cost model can also be used for contemplating all other cost elements revealed in the TCO calculation. Should cost modeling is the process of determining what a product/service should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins.
Combining 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 at the same time 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?
For a more detailed description, read the full article.