What do a

Volvo,
Wine Barrels,
and a
Vacuum
have in common?

1
Purchase 1998 Volvo V70, T-5 (Sweden) $ 39,000
Discount (6,500)
Sales tax (90-day rule) 0
Delivery to Port Hueneme (6-weeks) 0
Train/taxi to Port Hueneme 60
Luxury tax (10% over 36K) 0
European license/Insurance for 3 months 555
Airfare (Continental miles) 0
Total Cost to take delivery in Göteborg/PH $ 33,115
Purchase 1998 Volvo V70, T-5 (SD, CA) $ 39,000
Discount (2,500)
Sales tax (7.25%) 2,646
Luxury tax (10% over 36K) 50
European insurance for three months 0
Airfare (Continental miles) 0
Total Cost to take delivery in San Diego $ 39,196
Rent equivalent Volvo (Europe) $ 6,000
$ 45,196

2
“Exhausted” white oak red wine barrels
from Temecula winery $ 40 each
Issues:
• Choose and transportconsiderations:
Other ‘soft/indirect’ barrels ½ workday (2 people)
• Number
• Wages of of
barrels in oneand
employees trip lost
(no productivity
min.) 30
• Storage • capacity at PRDH/BMI
Head designer is billable at $90/hr. 30
• Fuel & 17’ box
• Inability to truck
choose(rent) $ 150
barrels at Napa (lower yield?)
Total• Direct
BarrelCost $ 1,350 ($45/barrel)
cost is 20% of direct costs of a chair
• (FYI... white
“Exhausted” Cost ofoaknew barrel
red wineisbarrels
$1,000)
from• Napa
Lackwinery
of storage capacity, as well as personnel
$ 22 to breakdown and
each
Issues: kit barrels, but...
• Establish
• Inspect relationship(s)
and arrange purchase for sustainable sources of supply
3 workdays (2 people)
• Build new business relationships
• Number of barrels in one trip (min.) for marketing
70 barrel furniture
• Enjoy
• Travel road trip...
expenses $ 300
• Other considerations
• Storage capacity at PRDH/BMI ??? 30
• Fuel & tractor semi-trailer (outsource) $ 1,050
Total Direct Cost $ 2,890 ($41/barrel)

3
21 pounds 17 pounds
~ $230 ~ $150 4
 All of the decisions involve the
application of (or lack thereof...)
TCO
(Total Cost of Ownership)
Total Ownership Cost – TOC
Total Cost – TC
Total Cost of Operation
Life-cycle Cost (TCO over time)
All-in-Cost
Relevant Cost of Ownership - RCO

5
And now for some academic stuff...

6
 What is TCO?
TCO is a Philosophy, Methodology, and Tool for
analyzing all the relevant quantitative and
qualitative costs of an acquisition, project,
investment, or relationship in order to make a
decision...

7
 TCO as a philosophy…
 TCO looks beyond the purchase price of a part,
subassembly, asset, investment, project, and/or service…
 TCO seeks to include all relevant information that will affect
the outcome…
 TCO considers qualitative considerations, as well as
quantitative…
 TCO seeks to understand short and long-term costs and
benefits (life cycle cost)…
 TCO explores customer and/or supplier relationships to
determine their value to the organization…

8
 TCO as a Methodology 1

 A TCO analysis attempts to determine the type of

buy, then applies certain processes and analytical
tools to support the decision process. In general,
TCO considers quantitative and qualitative
 Acquisition Costs
 Ownership Costs
 Post Ownership Costs

9
 TCO as a Methodology 4

Classification of Decisions:
Low Impact – low-cost commodity items
(e.g., copier paper)

Leverage – large purchases of items in competitive markets

(e.g., disk drives)

Strategic Item – large purchases from important suppliers

(e.g., commercial airline jet engines)

Critical Projects – large dollar volume infrequent purchase

(e.g., production facilities using various
technologies/processes)
1 Adapted from Supply Chain Management, Fawcett/Ellram/Ogden, Ch8
10
 TCO as a Methodology 4

Apply TCO to appropriate buy1

e.g., commodity items, e.g., alternative SC

supplier A v. B, configurations,
domestic v. offshore LCD v. Plasma,
Important supplier
relationships

Don’t waste a lot of time here

e.g., infrequent
purchases,
custom software,

1 Adapted from Supply Chain Management, Fawcett/Ellram/Ogden, Ch8

11
 TCO as a Methodology 4

 Many qualitative considerations can actually be quantified by

careful analysis

 There is a TCO issue in performing a TCO analysis. The cost/benefit

relationship needs to be analyzed before committing the time and
resources

 Garbage in, garbage out – care must be taken when determining

what and how to measure

 Management’s concern is the effect of the TCO object/decision on

the bottom line!

 TCO takes the emphasis off generic cost reduction initiatives to

support the strategic contributions of supply management
12
 TCO as a Tool
 TCO and Direct Materials, Direct Labor, and Overhead
 TCO and Services
 TCO and Inventory
 TCO and Capital Equipment
 TCO and NPV (net present value) Analysis
 TCO and International Sourcing
 TCO and the Logistics process
 TCO and Qualitative Considerations
 TCO and MRO, Production/Operations, Services
 TCO and Supply Chain Optimization

13
 TCO as a Tool
Inventory
 Non-Delivery
 Poor Quality
 Transportation and Packaging
 Carrying
 Working Capital !
 Insurance
 Property Taxes
 Floor Space
 Obsolescence/spoilage
 Administration
 ??????

14
 TCO as a Tool
Quantitative & Qualitative

KATV Inc. Differential analysis

ATV Engine
Supplier 1 m inus
Total Cost Analysis (annual) Supplier 2

Supplier 1 Supplier 2
Description formula amount formula amount

Total engine cost 12,000 x $500 6,000,000.00 12,000 x $498 5,976,000.00 24,000.00
Cash discount
n/30 6,000,000 x 0.10 x 30/360 50,000.00 5,976,000 x 0.10 x 30/360 49,800.00
discount available 6,000,000 x (0.10 x (10/360) +0.02) 136,666.67 5,976,000 x (0.10 x (10/360) +0.01) 76,360.00
Largest discount -136,666.67 -76,360.00 (60,306.67)
Tooling Cost given 22,000.00 given 20,000.00 2,000.00
Transportation cost (22,000 lb. LTL) 125 x 12,000 x 22 x $1.20/2000 19,800.00 100 x 12,000 x 22 x $1.20/2000 15,840.00 3,960.00
Ordering cost 12,000/1,000 x $125 1,500.00 12,000/1,000 x $125 1,500.00 0.00
Carrying cost 1,000/2 x $500 x 0.20 50,000.00 1,000/2 x $498 x 0.20 49,800.00 200.00
Quality cost 6,000,000 x 0.02 120,000.00 5,976,000 x 0.03 179,280.00 (59,280.00)
Delivery rating
Back Order (50% ) 12,000 x 0.01 x 0.50 x $15 900.00 12,000 x 0.02 x 0.50 x $15 1,800.00 (900.00)
Lost sales (50% ) 12,000 x 0.01 x 0.50 x $4,500 x 0.18 48,600.00 12,000 x 0.02 x 0.50 x $4,500 x 0.18 97,200.00 (48,600.00)

Total Cost 6,126,133.33 6,265,060.00

Difference, in favor of… ` 138,926.67 Supplier 1 (138,926.67)

Supplier 1 Supplier 2
Performance Metrics Weight Rating Final Value Weight Rating Final Value

Quality 0.25 93 23.25 0.25 88 22.00 1.25

Technology 0.20 85 17.00 0.20 94 18.80 (1.80)
Plant & Processes 0.18 87 15.66 0.18 82 14.76 0.90
Environmental 0.16 86 13.76 0.16 98 15.68 (1.92)
Financial 0.11 86 9.46 0.11 91 10.01 (0.55)
Responsiveness (inc. Delivery) 0.05 91 4.55 0.05 89 4.45 0.10
Business 0.05 88 4.40 0.05 95 4.75 (0.35)

1.00 88.08 1.00 90.45

Difference, in favor of… 2.37 Supplier 2 2.37 15

Principles of Supply Chain Management 3e (Wisner. et al.)
 TCO as a Tool
Quantitative
TCO-NPV Analysis
Machine A
Interest rate plus risk premium 8.25%
Years 0 1 2 3 4 5 Machine A Machine B
Present Value Present Value
CASH OUTFLOWS
Purchase price (612,000) (612,000) (510,000)
Installation and site preparation (9,000) (9,000) (9,000)
Sales tax 0 (38,542)
Setup and testing (6,000) (6,000) (2,000)
Expected repair and maint. 0 0 0 (7,500) (6,400) (6,800) (15,148) (14,029)
maintenance costs
Expected operating costs 0 (4,500) (6,625) (5,800) (5,675) (5,320) (22,095) (24,943)
Income tax on net revenues 0 (27,289) (31,358) (33,007) (32,259) (30,666) (122,115) (103,314)
CASH INFLOWS
Expected increase in revenue 0 142,325 165,000 180,000 175,000 167,000 653,985 560,758
generated by production
Expected salvage value 0 0 0 0 0 102,000 68,622 77,367
Expected depreciation Tax 0 20,790 20,790 20,790 20,790 20,790 82,464 69,826
shield benefit
18,713 6,124
9.28% 8.62%
(627,000) 131,326 147,807 154,483 151,456 247,004 18,713 6,124

16
 TCO as a Tool
Quantitative
Buy (US) Buy (China)
60,000 60,000
Per unit Annual cost Per unit Annual cost
Unit cost $30.00 $1,800,000 Unit cost $19.50 $1,170,000
Packing cost $0.75 $45,000 Packing cost $2.00 $120,000
Tooling $0.10 $6,000 Inland transport $0.12 $7,200
Freight $0.25 $15,000 Freight forward fee $0.02 $1,200
Ocean transport $2.40 $144,000
Marine Insurance $0.11 $6,600
Wiring Harness US. Port Handling $0.72 $43,200
Customs Duty $0.98 $58,500
Customs broker fees $0.03 $1,800
Savings US Transport $1.86 $111,600
$1.67 or ≈ 5.4% Warehouse Cost $0.50 $30,000
Is it worth the added risk?
Cost of capital $0.71 $42,353
Cost of hedging $0.08 $4,800
Administrative time $0.02 $1,200
Travel $0.33 $20,000
Tooling $0.05 $3,000

TOTAL COST $31.10 $1,866,000 TOTAL COST $29.43 $1,765,453

17
Purchasing and Supply Chain Management 4e (Monczka, et al.)
 TCO as a Tool
Supplier risks/considerations: Overseas business Risks:
 Design changes  Political stability
 Supplier integration in new product  Economic stability
development  Relations between countries
 On-going cost savings sharing agreements  Exchange rate volatility
 On-site technical support  Communication (language)
 Alignment of corporate cultures  Time zones
 Other joint improvement initiatives (e.g.,  Labor skill set
R&D)
 Accessibility to technology/engineering
 Financial stability
 Political corruption
 Means of production/process capability
 Travel
 Supply chain integration/processes
 Infrastructure (transportation,
 Lead time communications, energy, water, waste, etc.)
 Labor skill set  Local laws
 Quality and technology  Customer/culture
 Early supplier involvement  ?
 Price escalation
 Volume changes/capacity
 Cost sharing
 Delivery
 ?
Adapted from Purchasing and Supply Chain Management 4e (Monczka, et al.)
18
 TCO as a Tool
Quantitative
Running
Description Cost/lb. Shipment Annual Subtotal Formula

Cost per pound

Purchase price/pound 0.2900 11,600.00 139,200.00 Given
Ocean freight 0.0575 2,300.00 27,600.00 $2,300/40,000 = $0.0575
Import duties 0.0435 1,740.00 20,880.00 $0.29 x 0.15 = $0.0435
A. Landed cost (price paid, ocean freight, import duties) 0.3910 15,640.00 187,680.00 0.3910

Dock to stock
Ship to local warehouse/container 0.0063 250.00 3,000.00 $250/40,000 = $0.00625
Storage 0.0165 0.0014 55.00 660.00 $5.50 x 10 / 40,000 = $0.001375
Warehouse fee 0.0030 120.00 1,440.00 $6 x 20 / 40,000 = $0.003
subtotal 0.0106 425.00 5,100.00 0.4016

Interest on value of average inventory 0.0375 0.0360 1,440.00 17,280.00 $0.401625 x 240,000 x 0.18 / 480,000 = $0.036

B. Transportation & warehousing cost 0.0466 1,865.00 22,380.00 0.4376

subtotal
Warehouse to production cost
Freight 0.0038 150.00 1,800.00 0.4414 $150/40000 = $0.00375
Quality control 0.0010 40.00 480.00 0.4424 $2 x 20 / 40000 = $0.001
Purchasing and storing loss 2% 0.00916 0.0080 321.30 3,855.60 0.4504 40,000 x 0.02 x $0.401625 / 40,000 = $0.008
Factory yield 3% 0.01401 0.0120 481.95 5,783.40 0.4625 40,000 x 0.03 x $0.401625 / 40,000 = $0.01205
Spoilage/recall 0.0625 2,500.00 30,000.00 0.5250 $20,000 x 1.5 / 480,000 = $0.0625

C. Warehouse to production cost 0.0873 3,493.25 41,919.00 0.5250

Total cost of Guava Puree before SG&A 0.5250 20,998.25 251,979.00

SG&A 0.0787 3,149.74 37,796.85 $0.5250 x 0.15 = $0.07875

Total cost 0.6037 24,147.99 289,775.85 0.6037

Purchasing and Supply Chain Management 3e (Monczka, et al.)

19
 TCO as a Tool
Quantitative

Slide provided by Rey Huerta, President of Enterprise Logistics Solutions

Zero-Based Theoretical Analysis
20
 Component Outsourcing
 Buying components
 Buyer  supplier(s)  internal
customer(s) relationship
 Initiate PO and verify final receipt
 Less people dependent, fewer
interfaces
 Trend to eliminate monitoring and
inspections via supplier certification
 ???
Logistics Outsourcing
 Buying a service process
 Buyer  third party supplier(s) &
third party supplier(s)  ultimate
customer relationship
 Monitor series of service transactions
 More people dependent, more
interfaces
 Continuous monitoring over time to
create visibility
 ???

Arnold Maltz & Lisa Ellram suggest this modification to the TCO
framework is necessary to account for the extra interface, quality
measurement, and customer satisfaction costs involved in using TCO
analysis in Logistics decision-making.
TCO + Logistics = TCR (total cost of the relationship)
21
 TCO as a Tool
Qualitative
Pugh Importance
Requirements/Attributes Baseline Option 1 Option 2 Option 3
Matrix of Need
Quality 5 0 - - -
Cost 8 0 - - -
Supplier Logistics 10 0 - - 0
Development 10 0 0 0 0
Business 10 0 - 0 0
Technology 10 0 + - +
Physical environment 8 0 0 0 0
Human environment 4 0 + + +
OR 4 0 0 0 0
Handling 9 0 + + +
Machine Ride 5 0 0 0 0
Cornering 10 0 + + +
Acceleration 10 0 0 0 0
OR 4 0 0 0 0
Communication 10 0 - - -
Mate Physical persona (looks) 4 0 0 0 0
Spiritual persona (soul) 10 0 0 0 0
OR 10 0 + 0 0
? 10 0 0 + +
151
Sum of positives "+" 0 5 4 5
Sum of sames "0" 19 9 10 11
Sum of negatives "-" 0 5 5 3
Weighted sum of positives 0 43 33 43
Weighted sum of negatives 0 -43 -43 -23
Total weighted sum 0 0 -10 20
22
 So...what is TCO – really?
A Way of Thinking…
 Understand and concentrate on your core competencies
 Direct your focus from tactical to strategic
 Be proactive, not reactive
 Emphasize total cost, not just purchase price
 Understand the qualitative, less tangible issues in a procurement
 Measure, so you can manage
 Know the Voice of your Customer (VOC)
 Develop and align your key performance indicators (KPI’s) with VOC
 Gather data to gain knowledge
 Truth is not reality, truth is perception (Rey Huerta, President Enterprise Logistics Solutions)

23
 Supply Management & TCO
(Adapted from Supply Chain Management, Fawcett/Ellram/Ogden, Ch8)

Candidates for TCO analysis

 Large dollar spend items
 Regular purchases requiring cost information
 Procurements with significant unrecognized transaction
costs
 When purchasing can impact transactions costs, via
negotiation, changing suppliers, and/or improving
internal operations.
 When there is a desire for cross-functional involvement
in understanding item or service cost structure
 Capital purchases
 Value network optimization

24
 Supply Management & TCO
(Adapted from Supply Chain Management, Fawcett/Ellram/Ogden, Ch8)

Reasons for TCO analysis

 Performance measurement
 Framework for cost analysis
 Benchmarking performance
 More informed decision making
 Communication of cost issues internally and with suppliers
 Encourages cross-functional interaction
 Support external teams with suppliers
 Better insight/understanding of cost drivers
 Build a business case
 Support an outsourcing analysis
 Support continuous improvement
 Helps identify cost savings opportunities
 Prioritize/focus your time on high potential opportunities
25
Would all of these benefit from TCO
analysis?
• Study for advance degree, continue working, or both
• Buy a vehicle (new v. used, compact v. small SUV, …)
• Lease v. buy
• Rent v. own
• Investment A v. B
• Adjustable rate mortgage v. fixed rate
• 747-8 v. A-380
• Vacation options (Egypt v. Japan?)
• Drive v. Fly
• Make v. Buy
• Project A v. Project B.
• Supplier A v. Supplier B, or both
• Production Process A v. B v. C
• Remain in a bad marriage v. divorce
• Cloud based software v. computer resident
• Obama v. Romney economic plans
26
I wonder if a TCO mindset would have been beneficial in this situation ?
27