total-cost-of-ownership

What is the total cost of ownership (TCO)?

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.

Cost of ownership

Including stock management and depreciation.

Maintenance costs

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.

Connected Business Concepts

Vertical Integration

vertical-integration
In business, vertical integration means a whole supply chain of the company is controlled and owned by the organization. Thus, making it possible to control each step through customers. in the digital world, vertical integration happens when a company can control the primary access points to acquire data from consumers.

Backward Chaining

backward-chaining
Backward chaining, also called backward integration, describes a process where a company expands to fulfill roles previously held by other businesses further up the supply chain. It is a form of vertical integration where a company owns or controls its suppliers, distributors, or retail locations.

Supply Chain

supply-chain
The supply chain is the set of steps between the sourcing, manufacturing, distribution of a product up to the steps it takes to reach the final customer. It’s the set of step it takes to bring a product from raw material (for physical products) to final customers and how companies manage those processes.

Data Supply Chains

data-supply-chain
A classic supply chain moves from upstream to downstream, where the raw material is transformed into products, moved through logistics and distribution to final customers. A data supply chain moves in the opposite direction. The raw data is “sourced” from the customer/user. As it moves downstream, it gets processed and refined by proprietary algorithms and stored in data centers.

Horizontal vs. Vertical Integration

horizontal-vs-vertical-integration
Horizontal integration refers to the process of increasing market shares or expanding by integrating at the same level of the supply chain, and within the same industry. Vertical integration happens when a company takes control of more parts of the supply chain, thus covering more parts of it.

Decoupling

decoupling
According to the book, Unlocking The Value Chain, Harvard professor Thales Teixeira identified three waves of disruption (unbundling, disintermediation, and decoupling). Decoupling is the third wave (2006-still ongoing) where companies break apart the customer value chain to deliver part of the value, without bearing the costs to sustain the whole value chain.

Entry Strategies

entry-strategies-startups
When entering the market, as a startup you can use different approaches. Some of them can be based on the product, distribution, or value. A product approach takes existing alternatives and it offers only the most valuable part of that product. A distribution approach cuts out intermediaries from the market. A value approach offers only the most valuable part of the experience.

Disintermediation

disintermediation
Disintermediation is the process in which intermediaries are removed from the supply chain, so that the middlemen who get cut out, make the market overall more accessible and transparent to the final customers. Therefore, in theory, the supply chain gets more efficient and, all in all, can produce products that customers want.

Reintermediation

reintermediation
Reintermediation consists in the process of introducing again an intermediary that had previously been cut out from the supply chain. Or perhaps by creating a new intermediary that once didn’t exist. Usually, as a market is redefined, old players get cut out, and new players within the supply chain are born as a result.

Scientific Management

scientific-management
Scientific Management Theory was created by Frederick Winslow Taylor in 1911 as a means of encouraging industrial companies to switch to mass production. With a background in mechanical engineering, he applied engineering principles to workplace productivity on the factory floor. Scientific Management Theory seeks to find the most efficient way of performing a job in the workplace.

Poka-Yoke

poka-yoke
Poka-yoke is a Japanese quality control technique developed by former Toyota engineer Shigeo Shingo. Translated as “mistake-proofing”, poka-yoke aims to prevent defects in the manufacturing process that are the result of human error. Poka-yoke is a lean manufacturing technique that ensures that the right conditions exist before a step in the process is executed. This makes it a preventative form of quality control since errors are detected and then rectified before they occur.

Gemba Walk

gemba-walk
A Gemba Walk is a fundamental component of lean management. It describes the personal observation of work to learn more about it. Gemba is a Japanese word that loosely translates as “the real place”, or in business, “the place where value is created”. The Gemba Walk as a concept was created by Taiichi Ohno, the father of the Toyota Production System of lean manufacturing. Ohno wanted to encourage management executives to leave their offices and see where the real work happened. This, he hoped, would build relationships between employees with vastly different skillsets and build trust.

Dual Track Agile

dual-track-agile
Product discovery is a critical part of agile methodologies, as its aim is to ensure that products customers love are built. Product discovery involves learning through a raft of methods, including design thinking, lean start-up, and A/B testing to name a few. Dual Track Agile is an agile methodology containing two separate tracks: the “discovery” track and the “delivery” track.

Scaled Agile

scaled-agile-lean-development
Scaled Agile Lean Development (ScALeD) helps businesses discover a balanced approach to agile transition and scaling questions. The ScALed approach helps businesses successfully respond to change. Inspired by a combination of lean and agile values, ScALed is practitioner-based and can be completed through various agile frameworks and practices.

Kanban Framework

kanban
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.

Toyota Production System

toyota-production-system
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

six-sigma
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.

Read Also: Vertical Integration, Horizontal Integration, Supply Chain, Backward Chaining, Horizontal Market.

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