What Is TCO (Total Cost of Ownership) and How Do You Benefit From It?

What Is TCO?

Many companies use the total cost of ownership model to support buying decisions and negotiations, from both the customer and supplier perspective. TCO allows you to look deeper than the purchasing price when deciding whether to buy.

At its core, TCO is a procedure that estimates all the costs associated with an asset. This includes not only acquisition costs, but every direct and indirect cost throughout the asset’s life cycle, such as assembly, production, warehousing, distribution, administration, and more.

Estimating TCO helps you to identify known cost drivers as well as hidden costs – before you make the decision to invest.

The History of TCO

Different TCO procedures have been recorded since at least the 20th century. However, today’s understanding of TCO dates back to 1987, when the consulting company Gartner Group developed and promoted the total cost of ownership approach to assess costs for IT infrastructure. In the decades since, TCO has been approved and adopted globally.

Many different methodologies and software tools have been developed to analyze TCO in a variety of different contexts and industries. No matter the method or the application, the goal of TCO is always to understand the true costs of acquiring an asset.

The Tangible Benefits of TCO

TCO helps you save time and labor costs in the following ways:

• TCO makes it easier to compare different suppliers. With a TCO-based supplier evaluation system, you can measure and evaluate different supplier performances and decide which is the best fit.
• TCO helps to identify optimization potential. TCO improves the transparency of the cause-and-effect chain and can thus uncover potential areas for optimization.
• TCO increases cost understanding throughout the company. Breaking down the costs and sharing the information with employees allows them to understand cost optimization.
• TCO helps in deciding whether to make or buy. Evaluating the total cost of ownership is essential in making a rational choice when it comes to make-or-buy decisions.
• TCO helps define the economic order quantity. TCO calculations give you the basis for an economic order quantity (EOQ) evaluation, allowing you to minimize total costs of inventory.

The Intangible Benefits of TCO

TCO increases organizational transparency and responsibility in the following ways:

• TCO improves internal corporate communication. You can base decisions on consistent data sets and clear reasoning, reducing conflict and confusion among employees and management.
• TCO strengthens the negotiation process. When negotiating with suppliers, you can back up your position with results from the total cost of ownership evaluation.
• TCO is useful for product development and sales. Are you considering manufacturing/selling a product? Take a TCO perspective from the point of view of potential customers to see where you stand among the competition.

Breaking Down TCO: The 6 Cost Categories and Cost Elements

There are two levels when calculating the total cost of ownership: cost categories and cost elements (also known as cost drivers). Depending on the case at hand, you will have different cost categories and cost elements and you may structure these levels in different ways. Below, you can find a list of common cost categories. Most cost elements will fit into one or more of these categories.

There are 6 cost categories to calculate TCO, according to Ellram and Siferd (1993):

Problems Implementing TCO

Even though TCO offers tremendous benefits in nearly any situation, there can be issues in implementing the concept, especially if it is foreign to the people within your organization.

Copying a Total Cost of Ownership Model From Another Company

The main problem occurs when a company tries to copy a TCO model from another organization. This is doomed to fail due to the many complex factors that go into a proper TCO evaluation. No two situations are the same, and individual circumstances always have to be considered with TCO. Simply copying a model from another company is therefore not effective. That’s why we haven’t included a sample TCO model here.

Other Potential Problems

There are other issues that can come about when introducing TCO in a company. Employees must be educated and trained, internal operating processes may need to be changed, and conflict within the existing corporate culture may occur.

A lack of data sources and systems to help determine the cost elements is another common hurdle in using TCO effectively. Finally, the time it takes to complete the total cost of ownership evaluation can be an issue as well.

Despite these issues, we believe that TCO is an important part of the decision-making process. Efforts should be made to mitigate the problems associated with implementing TCO so that your company can reap its benefits.

• Sources: Ellram, L. M., & Siferd, S. P. (1993). Purchasing: The Cornerstone of the Total Cost of Ownership Concept.