Trident ConsultingTrident offers training, consulting and recruiting services to business professionals.

The predominant metric for most procurement organizations is cost savings. Traditionally, cost savings have been measured primarily on purchase price, usually against some form of standard cost based on historical prices. Over the years, more progressive organizations have come to realize that for many products, cost savings as measured against purchase price history is woefully inadequate as such a metric does not provide an accurate representation of the total cost of a product.

Concepts such as Total Cost of Ownership (TCO) and Life Cycle Costing (LCC) have gained momentum in these organizations, replacing the narrow Purchase Price Variance (PPV) approach. However, creating an accurate model to reflect the TCO or LCC of a product is complex and exceedingly difficult. One of the reasons this is so is because these models may vary from product to product, or even purchase to purchase. However, there are some general guidelines that can be followed in developing a model to estimate the total cost of a product over its lifetime.

What is Life Cycle Costing?

For the purposes of this discussion, Total Cost of Ownership is the outcome of the Life Cycle Costing process, and is defined below:  

“The total cost of ownership of machinery and equipment, including its cost of acquisition, operation, maintenance, conversion and/or decommission.” - SAE Int’l M-110.2

Research has provided estimates of the cost of each of the phases of a product’s lifecycle. These phases and their associated costs are loosely defined as Concept & Proposal (3%), Design & Development (12%), Build & Install (35%), and Operation & Support (50%). As you can see, the cost of a product increases as its lifecycle progresses, with roughly half of those costs accruing after its procurement.

What are the costs involved?

Identifying and estimating the specific costs to be included is perhaps the greatest challenge in developing a TCO model (and perhaps why many organizations simply don’t make the attempt). Each model is unique as it can be influenced by environmental, functional, market, product and many other variables. However, the costs associated with the majority of products can be generally categorized as Acquisition Costs, Operating Costs or Maintenance Costs.

Acquisition Costs are composed of more than just purchase price. Additional costs of acquisition may include: administration costs, engineering costs, installation costs, transportation costs, or training costs.

Operating Costs are those associated with direct labor, utilities, consumables, waste handling, disposal, and spare parts inventories.

Maintenance Costs are divided into Scheduled and Unscheduled Maintenance costs. Scheduled Maintenance costs include items such as: preventative maintenance, service life, fixed labor, and parts per year. Unscheduled Maintenance costs are accounted for by failures, repairs, lost production, and variable labor.

The bottom line

Accepting the previous statements that each TCO model is unique, the above model may not necessarily reflect the reality of any given category. However, the model is based on numerous studies conducted with a diverse set of products. Therefore, it is a good general model with which to start as the results are normalized to account for the majority of engineered products typically procured.

Regardless of the precision of the data relative to a specific product, the lesson here is that focusing exclusively on procurement price can be a costly decision in the long term.

Please share your experiences with LCC or TCO.