When evaluating a vendor or sourcing a supply for a component, most companies look at the vendor cost to provide the key component. Only cursory investigation is made into the transportation costs, inventory carrying costs, inspection costs or the time your money is tied up before you can sell the product to a customer. However, these costs are important and, when carefully investigated, can turn up some nasty surprises.
Total Cost of Ownership (TCO) is not a new concept. It has been applied for many decades, especially in the purchase of software/hardware systems and major pieces of machinery. A form of TCO was even applied in Napoleon’s army. Army ordnance engineers evaluated the effectiveness of cannon based on their range and type of projectiles, the time to move them from one position to another, the ease of maintenance, and the size of the crew needed to serve the cannon.
TCO has been used for many years to assess the true costs of large software systems or physical assets such as buildings or infrastructure. Through this analysis the true cost of ownership can be proved to be as much as 5-8 times the purchase price. This TCO analysis can help uncover hidden costs of ownership. For software systems, in addition to the cost of the software, buyers should look at any hardware costs (do you need to buy a new server or CPU because of the power requirements of this new system); maintenance costs, the costs of the inevitable upgrades; the need for a systems administrator or increased IT staff; the training costs to introduce personnel to the new capabilities of the system; the costs (time and material) to convert data from the legacy system to the new software system.
The purchase of a new piece of machinery should also be evaluated based on TCO criteria. There is no specific formula to assemble this cost factors, you have to visualize the life of the software or equipment and the costs that might be incurred at any stage. Generally, the costs fall into three categories: First, the acquisition costs, such as the purchase cost, set up costs, insurance costs, and environmental impact costs among them.
A second general category is the operating costs. This category includes utility costs, direct operation costs, maintenance and upgrade costs, and initial training costs.
The third category is the accounting calculation of the savings from the new asset, and revenue flows over the life time of the asset.
In the TCO evaluation you must decide the lifetime of the asset. Is this the depreciable life, the service life or the economic life? There may be considerable difference between these lifetimes.
In your future plans to add assets to your manufacturing operations, consider expanding the cost/ benefit analysis using the TCO criteria. In our next article we will look at the use of the TCO to evaluate parts vendors.
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