TOTAL COST OF OWNERSHIP (TCO)
Total Cost of Ownership (TCO) is a financial estimate intended to help buyers and owners determine the direct and indirect costs related to a product or system. It is a management accounting concept that can be used in full cost accounting or even ecological economics where it includes social costs.
Investopedia defines TCO as the purchase price of an asset plus the costs of operation. Assessing the total cost of ownership represents taking a bigger picture look at what the product is and what its value is over time. When choosing among alternatives in a purchasing decision, buyers should look not just at an item’s short-term price, known as its purchase price, but also at its long-term price, which is its total cost of ownership. The item with the lower total cost of ownership is the better value in the long run.
TCO looks at the cost of owning an asset in long terms by assessing both its purchase price and the costs of operation. Accordingly, TCO also distinguishes the difference between purchase price and the related long-term cost. By incorporating this into the acquisition process, it directly impacts outcomes in cost savings, vendor selection, prioritization of capital acquisition, and overall corporate budgeting.
Accurate procurement decisions should be based on TCO. The concept of TCO is to determine a product’s true cost not just based on the price but on all the costs it takes to purchase and maintain the product during the entire time it is owned.
Those who purchase or manage Information Technology (IT) departments have had a keen interest in TCO. TCO for these kinds of assets is a central focus in budgeting and planning, asset life-cycle management, and prioritizing capital purchase proposals. One of the best examples in today’s IT world is the usage of Cloud technology which has significantly reduced TCO in comparison to owning data centers and the related maintenance of such networks and facilities.
Life-Cycle Cost Analysis (LCCA)
TCO is also referred to as Life-Cycle Cost Analysis (LCCA). LCCA is the study of all the costs associated with processes, materials and goods from acquisition to ownership and maintenance, through to and including disposal. LCCA results in the estimated total cost of ownership (TCO) and can help determine the viability of a purchase or identify the best option among alternatives. (TechTarget)
Graco, an American manufacturer of fluid-handling systems and products based in Minneapolis, Minnesota put together a great and simple to follow white paper titled Understanding Total Cost of Ownership (TCO). The study focuses on estimation of all the collective expenses associated with purchasing and operating pieces of equipment for comparison. The formula presented by Graco is simple to follow and understand and it is as follow:
TCO = I + O + M + D + P – R
- I = Initial Cost
- O = Cost of Operation
- M = Cost of Maintenance
- D = Cost of Downtime
- P = Cost of Production
- R = Remaining Value (How much will the asset be worth in 5 years? 10 years?)
The formula presented can be used to compare two or more items in consideration to be purchased. The concept is very similar to calculation of Net Present Value (NPV). (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit.
The Graco calculation provides a beneficial assessment when comparing the purchase of parts/equipment however, the formula can be modified for other usage when it comes to configuring the TCO during the sourcing and procurement process.
Curt Finch of Project Smart, located in the UK is a project management resource that helps managers at all levels improve their performance posted Calculating Total Cost of Ownership when Choosing a Solution. Curt outlines a list to consider when calculating TCO to purchase software as follow:
- Software Cost
- License cost + base/server cost
- Client-side cost (if any)
- Purchasing process (how many vendors?)
- Operating Costs
- IT staff
- Management time
- Floor space
- Outage costs
- Back-up/recovery cost
- Annual cost
- Server cost
- Other product costs that are required, like a database, webserver, etc. (Even if you already have these things, you might need more, or to keep or support them longer)
- Risk cost
- Opportunity cost
Software Advice put out a brilliant and useful post titled Total Cost of Ownership Calculator which allows a user to enter various costs associated with on-premise vs. software as a service (SaaS) purchase. Software Advice also added the following footnote:
“This tool is meant to help you better understand the TCO implications for on-premise and SaaS software purchases. While it can help you estimate the TCO of your software purchase, calculations should not be considered exact as there are many things we weren’t able to include in this model. For instance, we do not include a net present value calculation for your cost of capital over the 10-year time frame. Nor do we model complex scenarios like organic or inorganic business growth. We’d like give a special thanks to Brian Sommer, Founder of Vital Analysis, and Jonathan Gross, VP and Corporate Counsel at Pemeco, for providing feedback and guidance in the creation of this tool.”
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