Effective Purchasing is far more than just getting a low price, and today it requires recognition of every cost involved in an acquisition – a concept known as Total Cost of Ownership (TCO).

A good definition of TCO is: “a structured method for identifying and understanding the total costs associated with the procurement and use of a commodity, product, or service which may include internal and/or external production costs”. TCO answers the question, “What is this really costing the organization?” because no matter what is being purchased, there are additional costs above and beyond the price paid to a supplier. TCO is about getting all of those costs identified and quantified, and includes a number of relevant but often overlooked elements, such as:

- Purchasing or Supply Chain administration
- Expediting and follow-up efforts
- Inbound transportation
- Inspection and testing
- Rework, storage, and scrap
- Downtime
- Customer returns 
- Lost sales

Total cost components may be segmented into one of three areas: Pre-Transaction, Transaction, and Post-Transaction. Pre-Transaction components include identifying a need, investigating sources, qualifying sources, adding suppliers to the internal system, educating the suppliers on the firm’s needs and operations, and working to understand supplier needs and operations. This may include approvals by a supplier selection team, site visits, and sample inspections. Transaction components include the net price paid, placing and managing the order, transportation costs, sample reviews, invoicing, inspections, total landed costs for international purchases, rejected product handling, and follow-up and improvements for future orders. This also means the impact of any problem such as rejected product, late deliveries, missing packing slips or other documents, expediting, and any activities that ensure quality product delivery. Post-transaction components include line fallout or failures, defective finished goods, rejected product, system or field failure, repair or replacement costs, loss of customer goodwill, additional communication, and possibly training.

The Total Landed Cost (TLC) is part of the Transaction portion of TCO for any organization that is sourcing materials, products, or services overseas. Some of the items that fall under TLC are special packaging, inland transportation, export licensing and taxes, export and import documentation, port fees at departure and arrival, wood fumigation or heat treatment, container screening, maritime insurance, ocean or air transportation, pipeline inventory, freight forwarding services, customs broker fees, customs review of documents, customs duties, certifications and inspections, harbor maintenance fees, and drayage fees.

A total cost focus provides a complete picture of all of costs incurred before, during, and after a transaction to support budgeting, informed decision making, lease versus buy comparisons, and managing a product or service over its useful life through to and including its afterlife and disposal. TCO allows for successful long-term financial planning and decisions to be made on a more informed basis than just price. It also recognizes that managing any problems will cost the organization money beyond the price paid. For example, the purchase of equipment today includes life cycle costing, a term often used in place of total cost of ownership when discussing the equipment buy. Life cycle costing includes all of the costs of testing and reviewing equipment/machinery prior to final selection; the purchase price, transporting, installing, upgrading/reconfiguring systems, testing, and training; and any follow-up, retraining, spare parts, and ongoing maintenance. Without good visibility of these elements, the lowest price supplier could very well end up as the highest total cost provider!

TCO is ideally a cross-functional initiative. For success the TCO team must have the time, funding, and senior management support for identifying the various cost components. In addition, information resources with sound numbers are critical to providing accurate costs, such as an organization’s transactional costs to administer a purchase order, pay an invoice, carry inventory, receive product in, inspect product or materials, and transport goods. And you need to be able to use that information to create a meaningful TCO. Here’s an example.

Many organizations use a simplified process to calculate and capture the cost of non-conforming goods and/or late deliveries. They track the performance over a period of time for all products or services provided by a supplier and identify the on time delivery and/or conformance percentage. If a particular supplier has delivered, say, 100 orders costing $20 each with only an 85% on-time delivery performance, the TCO of this product is actually $23.00 ($20 + $3.00) because of consistent late delivery problems.. 
The calculation is deceptively easy - multiply the 15% overall late delivery percentage times the price paid ($20) and add that to the price: 15% x $20 unit price = $3.00. Other cost elements can be similarly computed or estimated and added to purchase price to arrive at an item’s true TCO. 

As we have seen in this brief example, TCO can provide an improved, accurate picture of what it really costs to purchase anything. Are you able to do this today at your company?

This article is part of the monthly series authored by ISM’s Logistics & Transportation Group Board Members, who are current practitioners, consultants, trainers, and educators. In future columns, they will continue sharing their views on a number of Supply Chain and Personal Development topics.

Marilyn Gettinger is the owner of New Directions Consulting Group, which offers customized workshops and a team-oriented consulting method to assist organizations in being successful in their global supply chain management efforts. She can be reached at mgettinger@aol.com, or (908) 709-0656, or www.consultwithnewdirections.com