The total cost of ownership (TCO) estimates the total cost associated with purchasing and operating an asset. TCO is a more comprehensive way to understand the real cost of ownership. Thus, how much it really costs in the long-term to own something, with all its related direct and indirect purchase costs.
Understanding the total cost of ownership
The total cost of ownership places a single value on the life-cycle of a capital purchase.
This value is derived from every aspect of owning an asset, including costs relating to acquisitions, operations, training, documentation, and so forth. The calculation considers the direct and indirect (hidden) costs of purchase.
TCO is an important consideration in any scenario necessitating a large capital purchase.
A business wishing to overhaul its IT system needs to consider the cost of new software, installation, security, downtime, and employee training.
The purchase of a new business vehicle needs to consider the ongoing cost of fuel, maintenance, insurance, and depreciation.
Ultimately, TCO is used in business to gauge the viability of capital investment over time. It is often incorporated into a cost-benefit analysis.
Calculating the total cost of ownership
The particular parameters of a TCO calculation will vary from industry to industry.
Nevertheless, a standardized calculation allows decision-makers to compare the viability of otherwise unrelated assets.
Incurred costs are usually calculated from eight key areas:
Purchase price
How much did the investment cost to acquire before taxes?
Associated costs
Such as customs, duties, packaging, transport, or other payment terms.
Acquisition cost
Or the cost of actions undertaken by the purchasing department.
For example, acquiring new software may incur licensing, installation, or subscription fees.
Such as cleaning, training, inspecting, reporting, troubleshooting, or servicing.
Usage costs
Otherwise known as operating costs, these usually relate to employee wages or other overheads such as rent, electricity, and water.
Non-quality costs
What are the costs associated with meeting deadlines or initiating a non-compliance process?
Disposal cost
Or costs associated with the asset once it reaches the end of its usable life. This includes disposal, resale, or recycling cost.
Important TCO considerations
Determining the total cost of ownership is a nuanced process. Here are some important considerations for all businesses regardless of industry.
What are the hidden costs?
Spend some time considering the hidden costs of an asset purchase.
The better a business becomes at identifying hidden costs, the more accurately it will be able to calculate TCO.
What’s the cost of financing?
The method of financing used to fund the purchase will have an impact on TCO.
Decision-makers must liaise with finance and accounting to understand how factors such as deductions, expenses, and depreciation impact the final calculation.
How do the maintenance costs change over time?
Total cost of ownership is fluid. For example, the costs associated with maintaining a piece of equipment increase over time as the equipment ages.
Inflation also increases the cost of long-term maintenance.
What are the labor costs associated with owning?
Do not forget labor costs, which may decrease or increase as the result of new investment.
Winemaker Case Study
Consider a winemaker that needs to purchase a new forklift for its cellar operations.
The company has narrowed the purchase down to two potential models: Forklift A and Forklift B.
For the sake of this example, we’ll use the following formula to calculate the total cost of ownership:
TCO = initial cost (I) + cost of operation (O) + cost of maintenance (M) + cost of downtime (D) + cost of production (P) – remaining value (R).
Now, let’s run through each component step by step.
Initial cost
The initial cost of Forklift A is $25,000, while Forklift B retails for $28,000.
Cost of operation
Both forklifts will necessitate employee training on how to use them safely.
Since both models are electric forklifts, the company will also need to pay for electricity to charge the batteries.
Cost of maintenance
Periodic maintenance of the tires, tines, electric motor, and various other components will also be required over the forklift’s usable life.
Costs may also be incurred due to unexpected failures or inspections from a safe work authority that result in compulsory repairs.
Based on historical data, the winemaker costs the maintenance of Forklift A at $3,300 and Forklift B at $2,700.
Cost of downtime
Downtime costs for forklifts are especially relevant in the wine industry during the busy vintage period when grapes are harvested and the cellar is operating 24/7.
When a forklift is out of service, several processes such as crushing and pressing may be delayed.
There may also be a substantial loss of productivity in the bottling department since the process of bottling wine on a production line requires precision and coordination.
If the company is unable to unload glass bottles from a courier, for example, the line may have to be stopped until a forklift can be sourced.
For argument’s sake, the cost of downtime for Forklift A is $4,000 ($2,000 for 2 hours) and $2,000 ($2,000 for 1 hour) for Forklift B.
Cost of production
Forklift A has a total capacity of 3 tons, while Forklift B has a capacity of 2.5 tons.
This means that Forklift A has a lower cost of production because it can lift heavier loads and is more versatile as a consequence.
However, this advantage means the battery in Forklift A needs to be charged more frequently.
Remaining value
The winemaker has the policy to replace all forklifts after 15 years of service. After that time, it is estimated that Forklift A will be worth $5,000, while Forklift B will be worth $3,500.
Forklift Case Study
To calculate which forklift is most cost-effective, we can use the data and formula from above.
Forklift A
TCO = 25,000 + 3,300 + 4,000 – 5,000 = $27,300.
Forklift B
TCO = 28,000 + 2,700 + 2,000 – 3,500 = $29,200.
Despite the higher maintenance and potential downtime expenses, it is determined that Forklift A will cost the least to own over the 15-year period.
Is it worth owning a car?
Source: AAA
The best example to grasp the concept of Total Cost of Ownership is whether to own or not a car.
Since we give this for granted, that is a great exercise to challenge some of our assumptions about it.
Of course, if you live in a a state like California, you know it is impossible to get by without a car.
However, do you know your total cost of ownership for owning it?
This goes way beyond your leasing fee.
It comprises things like:
Insurance.
License registration.
Depreciation.
Fuel costs.
Maintenance, both ordinary and extraordinary.
In other words, if you consider something you take for granted, like owning a car, and factor in all the above, you go from a cost of $300-500 of your leasing fee to potentially 3-4x that!
That is what it entails to understand what ownership implies.
This will help you better understand possible alternatives, as now you have a clearer vision of the burden that ownership might have on your lifestyle.
This same approach can be brought to the business world.
You might want to consider when it makes sense to own or rent.
While rent might seem more expensive at first, you realize that it carries some hidden benefits.
On the opposite spectrum, you might think owning is always more convenient until you start calculating the hidden costs.
Key takeaways
The total cost of ownership is the purchase price of an asset plus the costs of operation.
Depending on the industry, the total cost of ownership can be calculated by considering costs grouped into eight categories: purchase price, associated costs, acquisition cost, cost of ownership, maintenance costs, usage costs, non-quality costs, and disposal cost.
When calculating the total cost of ownership, decision-makers must identify hidden costs. They must also understand that the TOC of an asset fluctuates because of age, financing method, inflation, and labor demand.
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Kanban is a lean manufacturing framework first developed by Toyota in the late 1940s. The Kanban framework is a means of visualizing work as it moves through identifying potential bottlenecks. It does that through a process called just-in-time (JIT) manufacturing to optimize engineering processes, speed up manufacturing products, and improve the go-to-market strategy.
The Toyota Production System (TPS) is an early form of lean manufacturing created by auto-manufacturer Toyota. Created by the Toyota Motor Corporation in the 1940s and 50s, the Toyota Production System seeks to manufacture vehicles ordered by customers most quickly and efficiently possible.
Six Sigma is a data-driven approach and methodology for eliminating errors or defects in a product, service, or process. Six Sigma was developed by Motorola as a management approach based on quality fundamentals in the early 1980s. A decade later, it was popularized by General Electric who estimated that the methodology saved them $12 billion in the first five years of operation.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
