Total cost of ownership
From Supply Chain Management Encyclopedia
Russian: Полная стоимость владения
Total cost of ownership (TCO) is a general term that refers to the analysis of aggregate cost over the lifetime acquisition of a product or service. TCO is currently applied to the acqusition of a variety of product-services including automobiles, factories, information technologies and financial services. In supply change management it is frequently used in relation to the analysis of change: notably, to the problem of switching suppliers. In a TCO analysis, relevant costs must be identified and their inclusion justfied. Factors that are not included in a TCO analysis are assumed to be equal across alternatives. This assumption, however, is generally not borne out in the practical world. For example, it is very difficult to quantify the flexibility and viability of alternative suppliers. We provide an example to illustrate the application of TCO analysis in supply chain management and to illustrate both the strengths and weakeness of the approach.
Suppose XInc is a manufacturer of transportation equipment and operates several assembly factories.
- One standard component (part 125) is used in all finished product. Weekly demand for part 125 is 8,500 units with a standard deviation of 500. The large quantity demanded is due to the fact that each finished product contains multiple units of component part 125
- A limited number of product 125 are defective upon receipt. One half of defective parts continue to the final product with a resultant average warranty repair cost of $1,000. XInc is sensitive to the safety issue surrounding all components parts. Engineers have clearly demonstrated that when part 125 is defective, the safety of the final product is not compromised. The other half of defects are identified during the production process with a rehandling, rework, and scrappage cost of $1.05 per unit
- The annual inventory carrying cost rate of part 125 equals 0.20
- XInc requires a high inventory availability service rate of 99.9%
- A proposal has been received from an alternative supplier and XInc has decided to apply TCO to the problem of evaluating the new proposal
With respect to the current supplier:
- They charge $2.00 per unit and sell in lot size quantities of 3,000
- The defect rate of part 125 from the current supplier is one in 10,000
- XInc, through a supplier evaluation program, has ascertained that the lead time of the current supplier is 10 days, with a standard deviation of 2 days
The potential supplier is offering:
- A selling price $1.93 per unit with a minimum lot size quantities of 5,000
- A lead time of 20 days with a standard deviation of 6 days
- A defect rate of one in 6,000
Which supplier should XInc select?
From the data provided, we can evaluate for each supplier the average amount of inventory and the subsequent annual inventory carrying cost, the annual cost of purchased goods, and the annual cost of defects. The first step is to identify the terms required for the analysis and ensure that the time period units are consistent. Since demand (D) is given on a weekly basis, we need to convert the lead time (LT) and its respective variance (σLT), given in days, to reflect weekly time units. As seen in Table 1, lead time (LT), the standard deviation in lead time (σLT), product value (v), and defect rate differ across the current and potential suppliers. Demand (D), the standard deviation in demand (σD), the carrying cost rate (c), and the z value relecting the inventory service level are identical across the two suppliers. Table 2 demonstrates how the average cycle inventory, safety stock, and inventory carrying cost for the expected inventory level were evaluated. The evaluation of safety stock was undertaken using the model provided in inventory model with uncertainty in demand and lead time. Next, the cost of purchased materials is the product of annual demand and the purchase price per unit. Finally the warranty cost is evaluated as the number of defects that are used in finished products multiplied by the $1,000 warranty cost plus the number of units detected within the plants mutiplied by the rehandling, rework, and scrap cost of $1.05. The annual total cost of the current and potential suppliers are $917,221 and $901,052, respectively. The TCO analysis shows that the potential vendor offers a savings of $16,169 over the current vendor.
The TCO assumes that any factors not in the analysis are constant across alternatives.
- Inbound transportation cost, terms of payment, supplier relational capabilities, ordering systems (including EDI and other electronic capabilities) were assumed to be equal across alternatives. Some of these factors (e.g., transportation cost) could be addressed without great difficulty. However, it is difficult to quantify other factors such as relational capabilities for inclusion in a TOC analysis. This is where supplier evaluation and supplier development becomes important additions that supplement the TCO approach
- Another important factor not accounted for in the TCO analysis is the impact of the final product defect rate on revenue. In this specific example, no information was provided on the issue. However, if XInc repeatedly opts for the low cost solution across multiple vendors, then the market might notice the decline in overall product quality. Revenue might then suffer
- The final decision as to the selection of which supplier should provide product part 125 resides in the trade-off that XInc is willing to make between cost and quality. The decision should thus be based on the strategic orientation of XInc (e.g., low cost leader; quality) and the ultimate position that the firm would like to occupy in the marketplace.
|Table 1: Variables in the TCO Analysis|
|Current Supplier||Potential Supplier|
|Weekly demand (D)||8,500||8,500|
|Standard deviation in demand (σD)||500||500|
|Lead time (LT)||10/7 = 1.43||20/7 = 2.86|
|Standard deviation in lead time (σL)||2/7 = .29||6/7 = .86|
|Carrying cost rate (c)||.20||.20|
|Replacement value (v)||2.00||1.93|
|Defect rate||1/10000 = .0001||1/6000 = .000167|
|A 99.9% inventory service level translation||z = 3.08||z =3.08|
|Table 2: Evaluating the Total Cost of Ownership|
|Current Supplier||Potential Supplier|
|Average cycle inventory = Order quantity / 2||= 3,000 / 2 = 1,500||= 5000 / 2 = 2,500|
|Safety stock = z √(LT × σD² +D² × σLT²)||= 3.08 √(1.43 × 500² + 8,500 × .29²) = 26,245||= 3.08 √(2.86 × 500² + 8,500² × .86²)=26,309|
|Total inventory cost =c × v × total inventory||=.2 × 2 ×(1,500+26,245) = 11,098||=.2 × 1.93 ×(2,500+26,309) = 11,120|
|Total product cost = Price per unit × units per year = v × units||= 2.00 × 8,500 × 52 = 884,000||= 1.93 × 8,500 × 52 = 853,060|
|Total defect cost = .5 × defects per year × 1,000 + .5 defects per year||=.5×1,000×(8,500 × 52)/10,000+.5×1.05×(8,500 ×52)/10,000=22,123||=.5 × 1,000×(8,500×52)/6,000+.5×1.05×(8,500×52)/6,000=36,872|
|Total cost = Inventory cost + Product cost + Defect cost||= 11,098 + 884,000 + 22,123 = 917,221||= 11,120 + 853,060 + 36,872 = 901,052|