Before making a major capital purchase, it is wise to understand all costs beyond just the purchase price. This video guides you through the four categories of the total cost of ownership model and offers advice on how to correctly apply this model to your critical purchasing decisions.
- When you make a major purchase, whether at home or at work, you are of course interested in the total cost of the purchase. In addition to the price itself, you're interested in sales taxes and delivery charges. If you bought this item from another country, there might even be customs duties to be paid. In a Total Cost of Ownership Analysis, or TCO, you strive to understand all these costs and more. You want to capture all the cost incurred after the item is delivered, as you use it. For example, after you buy a new car, how much do you spend on gas and oil and tires over the lifetime of the car? This tells you how much it costs to own and operate this car. And you want to bring all those costs over time back to a present value figure. Due to inflation, a dollar spent today is not the same value as a dollar spent next year. A TCO model provides one total figure for the purchase so that you can easily compare one purchase to another. It's based on the total cost of ownership figure. From your perspective as a professional buyer, there are four categories of total cost of ownership. The first category is the purchase price itself. Then there are acquisition costs. These are all costs associated with making the purchase, such as qualifying the supplier. And all costs associated with getting the purchased item. Such as transportation, duties and installation costs. With TCO, you also capture usage costs over the life of the product or service. For services, it's every expense that is not included in the purchase price. Think about your cell phone here. Usage costs include your monthly service fee from the service provider that sold you the phone. For capital equipment, it is all costs incurred in using the machine over its lifetime. Like maintenance materials and scheduled downtime and repair parts and service contacts. Quite often, this is a considerable amount of money and this is why we want to capture those costs. Back in the 1980's I worked for a semiconductor company that signed a huge contract with a new equipment supplier for a factory full of state of the art equipment. We were switching from an American manufacturer to a Japanese manufacturer, which was pretty common in those days. The machine, quite simply, puts patterns on the work in process by passing a light through a lens, much like a camera. The supplier gave a huge discount on the purchase price of the equipment because we were buying so much. Well, it did not take long to figure out why we were offered such a big discount. The source of light, let's call it a very expensive light bulb, for simplicity's sake. It cost 10 times more and lasted half as long when compared to our old equipment. We found this to be true of several key components. This of course not only meant increased usage expenses for parts, but increased machine downtime for scheduled maintenance and increased labor costs for very expensive repair technicians. We had never heard of total cost of ownership, but we figured out right away that the new machines were actually much more expensive than the old machines. It was a valuable lesson. The fourth category is end-of-life costs. Usually we think of salvaged value, or disposal costs as belonging to the accountants world. But these expenses, or salvage value in some cases, must be captured in a total cost of ownership calculation to get the full picture of the purchase. Remember that a total cost of ownership analysis is an expensive activity. It takes time and energy and lots of resources. You don't do it for all purchases, just the larger ones. And of course, some purchases don't actually have usage costs over time. Like raw materials and components for your production line, for example. For you would calculate total cost only. When you do a TCO analysis, focus on the big costs first as you look for cost savings and efficiencies. And don't forget that this model only guides you from a cost perspective. There are many other factors in your final decision.
- Explain the purchasing process.
- Define purchase order.
- Describe the intent of a purchasing policy.
- Distinguish types of purchasing structures.
- List the steps of selecting a supplier.
- Identify enablers for success in worldwide sourcing.
- Perform price and cost analysis.
- Measure supply management performance.