In this article, Total Cost of Ownership (TCO) will explained in practical terms. After reading, you will understand the basics of this powerful financial management tool.
What is the Total Cost of Ownership (TCO)?
Total Cost of Ownership (TCO) is a financial analysis tool to determine the direct and indirect costs of a system or product. Total Cost of Ownership (TCO) goes beyond the purchase price or execution costs to include the costs of all stages of ownership: acquisition, operating costs (such as maintenance and depreciation), costs arising from acquisition (such as training or the preparation of procedures), and opportunity costs. In short, the TCO consists of the short-term costs of a product, known as the purchase price, and the long-term costs. Together, they form the total cost of ownership.
Effective financial managers examine their products or services to gain insight into the total cost of ownership during the life expectancy of a product or service. Consumers are often concerned about the TCO and take these costs into account when comparing different suppliers and products.
Suppose a person buys a car with a low purchase price, but over time, more and more defects come to light and the car breaks down several times. The repair shop is far away and the parts are expensive. The car also loses value faster than comparable models. Ultimately, this consumer will end up pay more for the car—the cost of ownership—than if he had bought a slightly more expensive, technically better, and value-stable car.
Total Cost of Ownership (TCO) was popularised by the Gartner group at the end of the last century. However, the concept goes back many years, to the first quarter of the twentieth century. Over the years, many methodologies and software tools have been developed to analyse the TCO in different organisational contexts.
Usability of Total Cost of Ownership (TCO)
Total Cost of Ownership helps to reveal the hidden costs of a new technology. However, this tool is less effective at determining advantages. Traditional analyses, such as the Return on Investment (ROI), can determine this. This concerns matters such as increased productivity or higher customer satisfaction. These benefits are more subjective than the TCO, partly because benefits are more difficult to measure in absolute terms than direct costs, for example. If two solutions are found to offer the same benefits, but involve different costs, the TCO analysis can provide a solution and serve as a framework to evaluate the problem and the solutions.
Say that a retailer is looking for a customer management solution. A cloud solution can then offer an answer, but the benefits of this solution can be very similar to those of an in-house solution. However, the Total Cost of Ownership (TCO) can vary greatly. Different business models, delivery models, and cost structures are the reason for this.
First, the IT solution has a certain initial purchase price. The costs of this are: software, installation, transition costs, training, security, planning and maintenance, and support for the future. Companies use these costs as a guide to compare purchase and long-term costs. Organisations are not the only ones that use the Total Cost of Ownership (TCO). The TCO is also used for smaller purchases made by individuals. Total cost of ownership may be less relevant, but analysis is essential to prevent future losses and setbacks. These setbacks will not be avoided if only direct and indirect costs are taken into account.
Total Cost of Ownership (TCO) and lifetime
The Total Cost of Ownership (TCO) analysis exposes the cost of ownership over the full ownership cycle, including both obvious costs and hidden costs. However, there is no framework to determine how long the lifetime will last. There is room for interpretation and assessment.
In general, the following different lives are taken into account when defining the ownership cycle:
The depreciation period is the number of years for which owners charge depreciation costs. An example. Organisation X has made a purchase of ten thousand euros, and the purchase has a lifetime of four years with a residual value of two thousand euros. If the depreciation method is linear, this means that the value is depreciated by two thousand euros every year. This has an impact on, amongst other things, the total book value of assets, a lower taxable income, and tax savings for the owners.
Economic life is the period during which the asset generates more value than the cost of owning, operating, and maintaining it. The economic life of an asset ends when the costs exceed the benefits.
This is the period during which the asset affects the organisation’s accounting records. The duration of the different types of lives above can all vary and can all change the owners’ judgement about the entire length of the ownership life.
The life of ownership starts when the acquisition takes place. Costs occur as a result. The fact that the acquisition takes place does not mean that the asset arrives or is put into use. Ownership ends when the asset has no financial impact whatsoever. It also includes costs incurred as a result of disposal or decommissioning. So the asset is no longer part of the balance sheet.
As mentioned earlier, the Total Cost of Ownership (TCO) analysis distinguishes between two different types of costs.
Direct costs refers to all costs that are clear to everyone prior to the acquisition and during the planning and supplier planning. It includes:
- Purchase price
- Maintenance costs
The hidden costs, both direct and indirect, concern the following costs:
- Purchase costs related to identification, selection, ordering, buying, receiving, etc.
- Configuration costs
- Installation costs
- Implementation costs
- Operation costs (such as operating staff, transport, integration, energy costs, or fuel costs)
- Environmental costs
- Borrowing costs
- Decommissioning costs
- Other costs
Now it’s your turn
What do you think? Do you recognise the explanation about Total Cost of Ownership (TCO)? Do you calculate Total Cost of Ownership (TCO) when acquiring new assets? What are the advantages of using TCO? Do you have any tips or comments?
Share your experience and knowledge in the comments box below.
- Ellram, L. M. (1995). Total cost of ownership: an analysis approach for purchasing. International Journal of Physical Distribution & Logistics Management, 25(8), 4-23.
- Bhutta, K. S., & Huq, F. (2002). Supplier selection problem: a comparison of the total cost of ownership and analytic hierarchy process approaches. Supply Chain Management: an international journal, 7(3), 126-135.
- Ellram, L. M., & Siferd, S. P. (1998). Total cost of ownership: a key concept in strategic cost management decisions. Materials Engineering, 288(288), 288.
- Ellram, L. (1993). Total cost of ownership: elements and implementation. International journal of purchasing and materials management, 29(3), 2-11.
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