Level of analysis: Micro
Assessed aspects of sustainability: economic
Main purpose of the assessment: To determine direct and indirect costs relating to the purchase of a product or service.
Description of the methodology: It is a structured approach for calculating the costs associated with buying and using a product or service. Total cost of ownership takes the purchase cost of an item into account but also considers related costs such as ordering, delivery, subsequent usage and maintenance, supplier costs, and after-delivery costs.
Total Cost of Ownership (TCO) is a management-accounting oriented tool to find the lifetime costs of acquiring, operating, and changing something. The concept takes into account all costs that the purchase and the subsequent use of components entail in the entire value chain of the company, and thus expands the notion of purchasing cost by combining the life cycle cost effects with the acquisition price (Ellram and Siferd, 1998).
TCO analysis if properly done could bring out the “hidden” or non-obvious ownership costs that might otherwise be overlooked in making purchase decisions or planning budgets. It is a valuable tool for the evaluation and/or selection of suppliers and/or offerings, since it considers not just price, but also the cost effects of the alternatives (Wynstra and Hurkens, 2005). These cost effects could be ordering costs, stock keeping costs, inspection costs, maintenance, etc. These cost components are often divided into pre-transaction costs, transaction costs and post-transaction costs (Ellram, 1993).
The analysis begins with the design of a comprehensive cost model that completely covers the subject of the case, and which supports the purpose and needs of decision makers. The approach requires the quantification of qualitative factors into monetary terms, which enables supplier comparison not only on quantitative factors like price and delivery time but also on elements that are more difficult to measure, like quality. For example, a company that wishes to incorporate price and quality into a TCO model may wish to add to the purchase price the cost of rework on items that are below quality standards, or a cost supplement based on the actual percentage of quality defects times the cost for purchasing a replacement item. This approach incorporates all relevant costs in the model. As a result, comparisons of suppliers and their respective offerings are made on the basis of evaluation of all relevant performance characteristics on a monetary basis.
There are two methods for calculations: a monetary-based method and a value-based method (Ellram, 1995). The most well-known method is the monetary-based one, which allocates the costs of purchasing a good or service to the different cost components based on true costs. This is often done with management accounting methods such as Activity Based Costing. The monetary-based method is time-consuming, but also precise and relatively easy to interpret. Based on a detailed analysis, it is possible to derive a formula for future calculations, using the most decisive cost drivers (activities) and their accompanying costs. Such formulas could than be used to calculate the TCO of similar items.
The value-based method combines monetary with qualitative performance information, which is harder to express in monetary terms. On the basis of non-monetary, historical information, for instance vendor-rating scores of several suppliers, a total cost factor is calculated. Monetary-based method is useful in identifying cost drivers while value-based method is suitable for more qualitative aspects (Wynstra and Hurkens, 2005).
The most important applications of TCO are outsourcing decisions; supplier selection processes; evaluating the performance of (current) suppliers and; structuring important (purchase) process changes (Wynstra and Hurkens, 2005). Today, however, TCO analysis is used to support acquisition and planning decisions for a wide range of assets that bring significant maintenance or operating costs across a usable life of several years or more. TCO is often used to support decisions involving computing systems, vehicles, laboratory and test equipment, medical equipment, manufacturing equipment, and private aircraft, for instance.
The model provides an effective tool for assuring that every important cost item is included and that everything irrelevant is excluded in the business case.
TCO analysis if properly done could bring out the “hidden” or non-obvious ownership costs that might otherwise be overlooked in making purchase decisions or planning budgets.
Total cost of ownership is one of most important aspects in a more strategic view on purchasing and supply management.
It is a very useful tool for assessing the cost impacts of the products where the operational and maintenance costs are very high as compared to the capital costs.
The concept of Total Cost of Ownership (TCO) can be seen as a specific case of Life Cycle Costing, where the assessment takes the perspective of the product user/consumer.
The supply chain covered by TCO is identical to the underlying life cycle of products and services. Therefore the LCI data can be used for TCO models to provide monetary information as decision support.
TCO analysis is not a complete cost benefit analysis. Strictly speaking, TCO pays no attention to business benefits other than cost savings (and these show up in TCO analysis only when different TCO scenarios are compared). When this approach is used in decision support, it is usually assumed that the benefits from all alternatives are more or less equal, and that choices differ only on the cost side.
It is difficult to identify all costs, particularly if available information is insufficient. The available information also needs to be reliable. If too many uncertainties exist in relation to the realisation of certain cost savings, the confidence in the figures will decrease.
Calculations for TCO can easily become very complex.
The TCO of a specific product might be difficult to calculate if this is used in different endproducts, and even in different ways.
It is a somewhat narrow concept that only focuses on the product use/consumption phase of the product lifecycle and does not always include such costs as end of life and waste removal costs.
Opportunities for broadening and deepening LCA
Combining LCA with a TCO approach could provide a comprehensive understanding of environmental impacts and OPEX (operating expenditure) costs of the products and services.
TCO could play important role support in implementation of Green Public Procurement. Especially for procuring products such as IT equipments, photocopiers, etc, TCO assessment would justify purchasing of energy-efficient and green products by fully taking into account the OPEX.
Total cost of ownership is widely used in many private and public procurement bodies.
Threats for broadening and deepening LCA
Because of TCO’s limited focus, its use in supporting implementation of environmental policies, such as green public procurement, is limited.
Ellram, L. (1993) Total Cost of Ownership: Elements and Implementation, International Journal of Purchasing and Materials Management, 29(4): 3-10.
Ellram, L. (1995) Total cost of ownership: an analysis approach for purchasing, International Journal of Physical Distribution & Logistics Management, 25(8): 4-23.
Ellram, L. and Siferd, S. (1998) Total Cost Of Ownership: A Key Concept in Strategic Cost Management Decisions, Journal Of Business Logistics, 19 (1): 55-84.
Wynstra, F. and Hurkens, K. (2005) Total cost and total value of ownership, in: Essig, M. (Ed.), Perspektiven des Supply Management: Konzepte und Anwendungen, Berlin: Springer, pp. 463-482.