The total cost of your low cost items may be high

Roger OakdenProcurement, Supply Chains & Supply Networks

Calculating the total cost of ownership (TCO)

Know the Total Cost of Ownership for items.

Are you thinking about outsourcing the manufacture and delivery of a product, or renewing a current outsourcing contract? For manufacturing items, you may think of China or other countries in north or south east Asia. Why? because production costs are considered to be lower. Labour costs are still a dominant feature when companies select a low cost country (LCC); but are production costs all that should be considered?

I learnt about the Total Cost Of Ownership (TCO) many years ago, when consulting to a pharmaceutical company. It imported an ingredient from Germany, because high quality was the objective. Upon investigation, I identified that a local company could provide equal quality if they were awarded a five year supply contract. This allowed the supplier to finance new equipment and, as a bonus, transport and inventory cost were substantially reduced.

The belief in quality products from Germany had clouded management’s judgement about the value of buying from elsewhere. So it is today, with the belief that low production labour costs means the total cost of the finished product will also be low. However, the costs of addressing complexity, variability and constraints in global supply chains means that supply chain and logistics costs can be more than the total buying costs.

The breakdown of costs to analyse the TCO for an item should be done across six broad areas:

  1. Purchasing the item, including currency exchange rates, wage inflation in the producer country and financing
  2. Risks associated with contracting, producing and moving the item, including compliance with regulations
  3. Import and export across borders, including customs, duties and inspections
  4. Logistics, including transport and distribution
  5. Inventory form (e.g. raw materials, sub-assemblies, finished goods) and function (e.g. postponement, seasonal, quick response)
  6. Administration costs that are directly assigned to acquisition and movement of the item

Four areas (2 – 5) are the responsibility of supply chains and logistics professionals, so managing the TCO process should be one of their prime responsibilities. The supply chain group (which should include Procurement) role is the TCO analysis; account for all the potential variables and costs in the current or future contract and its potential competitors in other countries. Sadly, this is yet to be a standard practice in industry.

Implementing your TCO process

There is not a standard list of costs under the six headings, but in arriving at your list, always look for the costs that are not always ‘visible’ and counted. An example is when both parties are using a business language that is not native to either. Communicating the vision for the product and discussing technical and supply chain aspects will take longer. There is an added risk that suppliers may say ‘yes’ when they mean ‘no’ or are unsure.

The potential volatility along supply chains requires flexibility in adapting your supply chain maps. Regular reviews of the TCOs are needed for you to know the actual situation and whether changes to supply chains are required. To do the reviews, a structured approach to identifying, calculating, analysing and tracking the TCO requires access to data. However, the elements that make up your TCO will, most likely, be located in multiple locations within multiple internal accounting and operational systems.

Trying to achieve a believable TCO process using Excel spreadsheets is a task that will quickly become redundant – as a ‘cost saving’ measure. Instead it requires investment in an application that can hunt through multiple systems on a regular basis, to update the TCO actual figures for what may be many products. This information, plus market intelligence for selected potential suppliers and countries provides one aspect of visibility. By calculating and analysing the TCO situation, improved input is provided for more rational decisions about where items are made and distributed.

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About the Author

Roger Oakden

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With my background as a practitioner, consultant and educator, I am uniquely qualified to provide practical learning in supply chains and logistics. I have co-authored a book on these subjects, published by McGraw-Hill. As the program Manager at RMIT University in Melbourne, Australia, I developed and presented the largest supply chain post-graduate program in the Asia Pacific region, with centres in Melbourne, Singapore and Hong Kong. Read More...