A taxonomy of total cost of ownership models

Journal of Business Logistics, 1994 by Ellram, Lisa

Total cost of ownership (TCO) represents an innovative philosophy aimed at developing an understanding of the "true cost" of doing business with a particular supplier for a particular good or service.(1) TCO looks beyond price to include other major cost issues which affect critical purchases. Total cost of ownership is an inherently proactive approach to purchasing. Why bother to determine the TCO unless the data gathered will be used for decision making and analysis?

TCO includes a variety of cost related items. Whether a cost is included in the TCO analysis generally depends on the relative importance or magnitude of those costs for the items purchased. Thus, TCO involves judgment on the part of the user. Using Pareto's Law, the idea is to capture the 20% of the issues that make up 80% of the costs. TCO includes the price paid for the item, delivery, tariffs or duties, and may include other acquisition costs, such as order placement and supplier search and qualification. TCO includes costs related to actually receiving the order, such as receiving department costs, inspection, warehousing, and so on. TCO should also include costs of using the item, such as downtime caused by late, defective or incomplete shipments, warranty work, or customer returns associated with defective/poor quality materials or components. TCO and variations thereof are called many names: all-in-costs,(2) life cycle costing,(3,4) cost-based supplier performance evaluation,(5) and the total cost concept,(6,7) to name a few.

TCO data have many important uses in purchasing, and for the firm as a whole. Based on case studies of nine firms that use TCO approaches, some uses of TCO data are illustrated in Table 1. Just as there are many uses for these data, there are many approaches to TCO modeling. This paper will explore some of those models, based on the case study firms.

This paper is organized as follows. After discussing the benefits and barriers to TCO modeling, the study methodology is explained. This is followed by a brief description of the case study firms. Possible approaches to classifying TCO models are then discussed. Based on this discussion, the taxonomy developed from this research is presented and explained. Finally, the paper concludes with a summary and the implications of this taxonomy for research and practical TCO implementation.

TABLE 1

REASONS FOR USING TOTAL COST OF OWNERSHIP

* Support supplier selection Request for Proposal, Quotation and/or Bid

* Give supplier awards for excellent performance

* Drive supplier improvements, identify priorities

* Plan future supplier performance

* Measure ongoing supplier performance

* Provide data for negotiations

* Forecast new item performance based on historical data

* Concentrate resources on the "important few" purchases

* Compare supplier performance (benchmark) against others, self over time

* Support strategic alliance efforts

* Supply base reduction/volume allocation decisions

TCO BENEFITS

The benefits of adopting a TCO approach in purchasing are many. Despite limited adoption of TCO models among firms, the benefits of using such models are well documented.(8,9,10,11,12,13,14) TCO, with its broad cost perspective, represents a very different approach to understanding and managing purchase costs.

From the case study firms, five major TCO benefit categories were developed. These are detailed in Table 2. The benefits include improved supplier performance measurement, improved purchasing decision making, improved internal and external communications, better insight and understanding into purchased goods/services and supplier performance, and support of the firm's continuous improvement efforts. These benefits are closely related to each other. For example, improving supplier performance measurement leads to improved decision making, can improve communication with suppliers by using actual performance data, and increases insight into supplier performance issues, which in turn highlights potential areas for continuous improvement efforts. Thus, the benefits have a synergistic effect.

TABLE 2

BENEFITS OF TOTAL COST OF OWNERSHIP

PERFORMANCE MEASUREMENT

Good framework to evaluate suppliers.

Concrete way to measure results of quality improvement efforts.

Excellent tool for benchmarking.

DECISION MAKING

Forces purchasing to quantify tradeoffs.

Good bias for making supplier selection decisions.

More informed decision making.

Creates a structured problem solving environment.

COMMUNICATION

Excellent communication vehicle between firm and suppliers.

Way to get other functions involved in purchasing decisions.

INSIGHT/UNDERSTANDING

Provides excellent data for trend analysis on costs.

Provides excellent data for comparing supplier performance.

Provides excellent data for negotiations.

Provides critical data for target pricing.

Requires purchasing to develop an awareness of the most significant non-price factors that contribute to TCO.

Long-term orientation by focusing on "big picture."

SUPPORTS CONTINUOUS IMPROVEMENT

Identifies where suppliers should focus improvement efforts--drives suppliers to work on "right thing."