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Total cost of ownership
An analysis approach for purchasing
Lisa M. Ellram
Arizona State University, Tempe, Arizona
Background
Total cost of ownership (TCO) is a purchasing tool and philosophy which is
aimed at understanding the true cost of buying a particular good or service
from a particular supplier. While there have been references to the TCO
approach in the literature for some time[1,2], many firms, particularly in the
USA, have been slow to adopt TCO.
Total cost of ownership is a complex approach which requires that the
buying firm determines which costs it considers most important or significant
in the acquisition, possession, use and subsequent disposition of a good or
service. In addition to the price paid for the item, TCO may include such
elements as order placement, research and qualification of suppliers,
transportation, receiving, inspection, rejection, replacement, downtime caused
by failure, disposal costs and so on. TCO may be applied to any type of
purchase. The cost factors considered may be unique by item or type of
purchase[3].
Based on case studies of 11 organizations that are actively using formalized
TCO approaches in purchasing, this article explores the answers to the
following questions:
●What are the theoretical underpinnings of TCO analysis?
●What are the benefits sought in TCO implementation and what are the
barriers which slow down TCO adoption?
●What are the potential uses of TCO models?
●Is there a relationship between the type of TCO model selected and its
primary use?
●Are there organizations which use their TCO model for more than one
such primary use? Do certain types of TCO model better lend themselves
to multiple uses?
●What are the implications of these findings for TCO model development
and modification?
Received June 1994
Revised January 1995
Revised May 1995
The author would like to thank the Center for Advanced Purchasing Studies and the Arizona
State University College of Business, Alumni Association and Council of 100 for their support in
this research.
International Journal of Physical
Distribution & Logistics
Management, Vol. 25 No. 8, 1995,
pp. 4-23. © MCB University Press,
0960-0035
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ownership
5
Before proceeding to the case studies, TCO is compared with other supplier
selection and evaluation systems.
TCO versus other methods of supplier evaluation and selection
Traditional approaches to supplier selection and ongoing evaluation include
selecting and retaining a supplier based on price alone, or based primarily on
price, or qualitatively evaluating the supplier’s performance using categorical
or weighted point/matrix approaches[4,5]. While the latter approaches are
preferred to a “price only” focus, they tend to de-emphasize the costs associated
with all aspects of a supplier’s performance, and generally disregard internal
costs. Examination of such costs is a strength of the TCO approach.
Selection and evaluation approaches which are closely aligned with TCO
include life-cycle costing[2,6], zero-base pricing or all-in-costs[7], cost-based
supplier performance evaluation[8], and the cost-ratio method[4,5]. None of
these approaches has received significant, widespread support in the literature
or in practice for a variety of reasons.
Life-cycle costing focuses primarily on capital or fixed assets[2,6]. The
emphasis is understanding the purchase price of the asset and also on
determining how much it actually costs the organization to use, maintain and
dispose of that asset during its lifetime. Pre-transaction costs tend to be de-
emphasized. The life-cycle approach is congruent with TCO, but represents
only a subset of TCO activity. TCO is broader in scope and includes the pre-
purchase costs associated with a particular supplier.
Zero-base pricing[7] and cost-based supplier performance evaluation[8] both
advocate understanding suppliers’ total costs. In contrast to TCO, zero-base
pricing focuses heavily on understanding the supplier’s pricing structure and
the supplier’s cost of doing business. Cost-based supplier performance
evaluation has a narrower scope than TCO by focusing primarily on the
external costs of doing business with a supplier rather than on both the internal
and external costs, as does TCO.
Recently, there have been several articles published which focus specifically
on the total cost of ownership. Handfield and Pannesi[9] explore understanding
total cost of ownership specifically for components, using the product life-cycle
approach. They note that TCO components’ issues are directly related to where
the component is its life cycle and that the component life cycle may not be
related to the overall product life cycle.
Carr and Ittner[10] present an overview of total cost of ownership approaches
used by several organizations. The models which they present are all modified
versions of the cost ratio method. Using the cost ratio method, an organization
usually identifies several key factors that increase costs. Factors that increase
costs, such as those resulting from poor quality and late delivery, are added to
the total purchase price. Dividing these total costs by the total purchase price
yields an “index”. This index is then used as a multiple for future bids/prices
from the supplier to evaluate the true “total cost of ownership” of doing
business with that supplier. Ellram and Siferd[11] developed a conceptual
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framework for costs to be included in TCO analysis. Ellram used case studies of
organizations which have used formal TCO analysis to develop a framework
for TCO implementation[3,12]; Ellram[13] also developed a taxonomy for
classifying TCO models according to the type of buy, also known as “buy class”
(type of purchase), and whether the TCO model is standard or unique.
Approaches similar to the total cost of ownership in purchasing have been
advocated in the logistics literature[14-17] and strategic management
literature[18] as means of understanding total costs throughout the supply
chain. Previous work in logistics supply chain costs is conceptual in nature.
Such work does highlight the importance of understanding total cost of
ownership related to purchasing in developing a realistic cost perspective of the
total channel. Thus, TCO concepts can make a significant contribution to
understanding total channel costs.
Lack of understanding of TCO can be very costly to the firm. Poor decisions
will likely result, hurting the firm’s overall competitiveness, profitability,
pricing decisions and product mix strategies [3,7,11,12,14-22].
This study extends the previous research by considering the primary
motivation for using TCO and relating that to the type of TCO model chosen.
This article makes a contribution by analysing actual practices of firms that
use a variety of TCO approaches and developing alternative frameworks for
TCO. Many previous studies of total cost analysis in both the purchasing and
logistics literature have been broad and conceptual[4,5,15,16,23], or limited to
one or two case studies[2,6,8].
Theoretical underpinnings for TCO analysis
Economists have discussed the importance of going beyond price to encompass
transaction cost analysis in purchasing from external sources. Economists tend
to focus on asset specificity (the need to invest in specific assets to support
certain activities) and the likelihood for opportunistic behaviour to occur.
Economists have viewed transaction cost analysis primarily from a make-or-
buy perspective[24-26], considering internal production of goods or services
versus buying in the market. However, transaction costs are the foundation for
TCO analysis as well.
While TCO analysis can be applied to the make-or-buy decision, it should
also be applied after an organization has determined that it will use a third
party (buy) rather than an internal source (make). Transaction costs can vary
significantly among suppliers and can be an important decision factor. From
this perspective, transaction cost analysis in the economics literature provides
the theoretical basis for TCO analysis in the purchasing and logistics literature.
Turning to applications of transaction cost analysis in the marketing
literature, Heide[27] notes that transaction specific investments may involve
human assets that are difficult/costly to replace. In terms of purchasing, this
could include suppliers’ employees, such as engineers, account executives and
customer service personnel who have specialized knowledge and are dedicated
to making the account run smoothly. For example, a supplier’s concurrent
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engineering and after-sales support may significantly lower the buying
organization’s cost of doing business with this supplier versus the free market.
In dealing with external uncertainty – which creates an environment
conducive to opportunistic behaviour – the marketing literature notes that
opportunism is decreased when there is an interpenetration of organizational
boundaries[28]. This is relevant to the total cost of ownership of buyer-supplier
relationships in that there are costs which should be recognized which are
associated with forming such close buyer-supplier relationships. These costs
include dedicating assets, such as key account personnel. Likewise, there
should be a reduction in transaction costs from creating such close
relationships. Examples of this include a reduction in the costs of soliciting and
evaluating bids and proposals from numerous suppliers, and searching for and
evaluating potential new suppliers.
Previous literature on TCO analysis defined transaction costs based on costs
that are incurred prior to actual sale; costs associated with the sale, including
price; and costs after the sale has occurred, including disposal[3]. Such cost
considerations are supported by the marketing literature’s application of
transaction cost analysis to specific assets and opportunism. TCO analysis is a
valuable tool and philosophy to support the application of the theory of
transaction cost analysis to buyer-seller relationships.
Barriers to and benefits of TCO
The complexity of TCO may limit its widespread adoption. Lack of readily
available accounting and costing data in many organizations is a major barrier.
This situation has the potential to change as more organizations implement
activity-based costing[13,22,29]. However, this change has been very slow in
coming. Another complicating factor is that there is no standard approach to
TCO analysis. Research and a review of the literature have indicated that TCO
models used vary widely by company, and may even vary within companies
depending on the buy class and/or item purchased[3,6,7,11,19,21]. Thus, user
training and education are probably needed to support TCO efforts. Further,
TCO adoption may require a cultural change, away from a price orientation in
procurement and towards total cost understanding[3,11]. That potential for
cultural change is a major reason why TCO is regarded as a philosophy, rather
than as merely a tool. An additional factor which complicates TCO is that TCO
costs are often situation-specific. The costs which are significant and relevant to
decision making vary on the basis of many factors – such as the nature,
magnitude and importance of the buy[13,20].
However, TCO provides many benefits that are documented in the
literature[2,7,8,11] and confirmed by case studies[12]. Some of the primary
benefits of adopting a TCO approach are that TCO analysis:
●provides a consistent supplier evaluation tool, improving the value of
supplier performance comparisons among suppliers and over time;
●helps clarify and define supplier performance expectations both in the
firm and for the supplier;
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●provides a focus and sets priorities regarding the areas in which supplier
performance would be most beneficial (supports continuous
improvement), creating major opportunities for cost savings;
●improves the purchaser’s understanding of supplier performance issues
and cost structure;
●provides excellent data for negotiations;
●provides an opportunity to justify higher initial prices based on better
quality/lower total costs in the long run;
●provides a long-term purchasing orientation by emphasizing the TCO
rather than just price.
This list of benefits is by no means comprehensive. It provides a summary of
some of the key benefits of adopting a TCO philosophy in purchasing. It is
important to note that none of the organizations studied use TCO for all
purchases. The use of TCO is reserved for certain items/services where the
organization feels that such analysis can provide greatest benefit. Before
proceeding with the research results, the next section will discuss the research
methodology used.
Methodology
This research involved case studies of 11 organizations which were actively
involved with and used formalized TCO models in purchasing. A formalized
model is defined as a written, documented method for determining the total
costs associated with the acquisition and subsequent use and disposition of a
given item/service from a given supplier. As previously mentioned, much of the
current literature on TCO is anecdotal or descriptive in nature[17,23], or
involves only one case study firm[6,8]. Thus, because of the limited amount of
data available on TCO models in the literature, this research is exploratory in
nature. It seeks to describe and understand TCO analysis in depth, rather than
provide a broad but limited picture of TCO practices among a large population
of organizations.
Interview approach
The interview guide used in the research was developed based on the research
questions of interest and combined with a review of the relevant literature. Both
academics and purchasing practitioners reviewed the interview guide for
content and clarity. The interview guide was also pre-tested with one firm. The
interview guide was modified based on these inputs.
Sample selection
Owing to the relatively limited availability of firms which actively use TCO in
purchasing, the case study firms in this research are not a random sample. This
purposive sample was developed based on the author’s knowledge, a review of
the literature and recommendations of purchasing practitioners. Each case
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study firm was pre-screened over the phone to determine, first, whether it
actually used a formalized TCO model, in terms of the above definition, and,
second, whether it would be willing to participate in the research as a case
study.
Case study firms
The use of TCO models is widely dispersed across industries, as shown in
Table I. The convenience sample includes: two semi-conductor firms and a
semi-conductor consortium; one manufacturer of diversified electronics and
computer components; one manufacturer of telecommunications systems; one
manufacturer of transportation vehicle components; a defence electronics
manufacturer; an oil company; a manufacturer of medical systems; a
manufacturer of defence aviation products; and a manufacturer from the
process industry.
While this is clearly not a representative sample, there are two issues to
consider. First, high technology companies often lead purchasing innovations
due to the importance of supplier performance to their products and the
relatively high dollar value of purchased items to the firm. Second, the research
did not find a common pattern among TCO models across high-technology
companies.
Potential use of TCO models
The potential uses of TCO models are closely related to the benefits of TCO
models pointed out above. In general, based on the case study firms, there are a
number of uses for TCO model data. However, for each firm, there is one
primary use for the data which drives the development of the model. That
primary use is based on the impetus for implementingTCO. The two lists which
follow show the uses for TCO data identified by the case study firms, followed
by the primary reason each case study firm uses TCO.
Table I.
Industry representation
of case studies
Industry Number of organizations
Oil (Shell) 1
Semi-conductor (Intel, Motorola SPS) 2
Semi-conductor consortium (SEMATECH) 1
Telecommunications equipment and support (Northern Telecom) 1
Defence/electronics (Motorola) 1
Diversified electronics/computer (Texas Instruments) 1
OEM manufacturer for transportation industry (Firm W) 1
Medical systems (Firm X) 1
Defence/aviation (Firm Y) 1
Process industry (Firm Z) 1
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Reasons for using TCO
These include:
(1) support supplier selection/RFP, RFQ, RFB:
●new suppliers;
●choose among existing suppliers;
(2) give supplier performance recognition awards;
(3) drive supplier improvements, identify priorities;
(4) drive major process changes;
(5) plan or anticipate future supplier performance;
(6) measure ongoing supplier performance;
(7) provide data for negotiations;
(8) forecast new item performance based on historical data;
(9) concentrate resources on important few purchases;
(10) compare supplier performance (benchmark) against others and self over
time;
(11) support strategic alliance efforts;
(12) supply base reduction/volume allocation decisions.
Primary reasons for TCO adoption
These include:
●supplier selection decisions: e.g. Intel, Motorola SPS, SEMATECH, Firm
W, Motorola GSTG, Firm Z;
●measure ongoing supplier performance (evaluation): e.g. Texas
Instruments, Northern Telecom, Shell;
●drive major process changes: Firm X, Firm Y.
Primary use of TCO
As indicated, there are three primary uses of TCO model data by the case study
firms: supplier selection, supplier evaluation or measurement of ongoing
supplier performance, and to drive major process changes/re-engineer. The case
study firms lean towards supplier selection as the primary driving force behind
TCO adoption. The six firms which use TCO primarily for supplier selection
also use TCO data for a variety of other purposes, from driving supplier
improvements to negotiating. There is no strong pattern among the secondary
data uses for those who cite supplier selection as a primary TCO use.
The three organizations which indicate evaluation of ongoing supplier
performance as the primary reason for using TCO modelling, also note driving
performance improvements and providing data for negotiations as secondary
reasons for TCO modelling. Thus, in some sense, these firms were using TCO to
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support supplier selection decisions. In addition, these organizations use their
TCO data for benchmarking supplier performance among suppliers and for
looking at supplier performance improvements over time. Another use of data
noted by both of the “performance evaluation”-focused firms was in allocating
volume among the existing supply base and/or reducing the existing supply
base.
The two organizations which use TCO primarily to analyse and drive process
changes take a very broad, systemic approach to TCO analysis. Rather than
focusing on purchasing-related issues and supplier performance only, these
organizations used TCO analysis to support broad outsourcing/make/buy
decisions that had implications far beyond purchasing. While other
organizations use TCO analysis to support strategic and/or make or buy
decisions, it was not the driving force. The firms which focused on driving
process change do not use TCO for ongoing supplier evaluation, but do use it to
support the selection decision.
One surprising finding is that only four of the firms – Texas Instruments,
Northern Telecom, Shell and Firm Z – use TCO for both supplier selection and
ongoing supplier performance evaluation. In other words, firms who use TCO
for supplier selection generally do not use TCO for ongoing evaluation of the
supply base. Firms who use TCO for ongoing supplier evaluation tend not to
use TCO data for supplier selection of new suppliers. This will be discussed in
greater depth later in the article.
Approaches for determining TCO
There are two major approaches to determining TCO used by organizations
considered in this research: dollar-based and value-based approaches.
Dollar-based approach
A dollar-based system is one that relies on gathering or allocating actual cost
data for each of the relevant TCO elements. Thus, if a dollar-based model
indicated a TCO of, say, US$15.32 for a component, it would be possible to trace
the costs of the items that make up that TCO on a cost element by cost element
basis. An example of the dollar-based approach to TCO modelling is shown in
Figure 1. While determining which cost elements to include and gathering the
data to determine the TCO may be complicated, explaining the results of a
dollar-based approach is relatively straightforward.
There is a variation on the dollar-based approach which uses formulae to
allocate actual costs by item purchased by supplier. The formulae are based on
the effort or resource level required to support a given activity, much like the
practice of activity-based costing. One type of activity clearly related to a
particular purchase from a particular supplier is inspection. Thus, such
systems determine the cost of inspection and develop a formula for allocating
the cost of inspection to purchases based on the effort required to inspect. When
parts are inspected, the parts receive an allocation of actual inspection costs for
the period during which the inspection occurred. Those parts which do not
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require inspection do not receive the inspection allocation. Thus, this approach
creates a more accurate picture of the true cost of doing business. This creates
a methodology for using the TCO approach for repetitive decisions, rather than
creating a new analysis each time or for each commodity.
As mentioned above, using activity level to allocate costs is the basis for
activity-based costing, also known as ABC. This principle improves matching
activities which drive costs with the items that benefit from those activities, and
was a key factor in the development of both Texas Instrument’s and Northern
Telecom’s total cost systems. A further discussion of ABC is beyond the scope
of this article (see[22,29,30]).
Value-based approaches
A value-based TCO model combines cost/dollar data with other performance
data that are often difficult to “dollarize”. These models have a tendency to
<300.00>
––––––––––
Price paid, F.O.B. origin
(12.632/unit) $12,000.00
Delivery charge 500.00
Quality:
Cost to return defects
Inspection (in-house)
Delay costs (downtime)
Rework parts
Rework finished goods
Subtotal quality costs
$100.00
300.00
–
–
200.00
$600.00
Technology
Our engineers at their facility
<credit> Their engineers at our facility
<credit> Their design change to improve yield
Subtotal technology
Cost of delivery delays
Charge for not using EDI ($50.00/order)
Support/service
Subtotal support/service
Total costs
TCO per unit (total costs/units shipped)
Units shipped
$1,500.00
––––––––––
$1,200.00
––––––––––
$104.00
150.00 ––––––––––
$254.00
$14,554.00
950
––––––––––
$15.32
––––––––––
Figure 1.
Dollar-based TCO
illustration
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become rather complex, as qualitative data are transformed to quantitative
data. They often require very lengthy explanations of each cost category. An
abbreviated illustration of this method is shown in Figure 2.
As illustrated in Figure 2, some value-based TCO models do calculate a total
cost of ownership. The total cost derived from value-based models is not
directly traceable to dollars spent in the past, spent currently or estimated to be
spent in the future, as are the dollar-based TCO results. However, the way in
which the supplier’s performance is scored within categories and points
allocated among categories reflects the buying organization’s estimate of the
cost of various performance discrepancies. Organizations which choose a value-
based approach prefer it because, as costs and the organization’s priorities
change, the “weighting” of cost factors can be changed accordingly. Value-
based models require a great deal of fine tuning and effort to develop the proper
weightings and point allocations so that they reflect the TCO. Like dollar-based
TCO analysis, value-based models are derived from historical data and/or
Figure 2.
Value-based TCO
illustration
Total cost of item per dollar purchased = [(100 - score)/100] + 1
Category
Quality
Delivery
Technology
Support
Maximum points
30
20
30
20
__
100
Example: Delivery
“% of line items delivered
on time” (A)
Percentage of
maximum points
allotted
(B)
Score
(A x B)
100%
99%
95-98%
90-94%
85-89%
80-84%
<80%
100% of
maximum
95%
85%
70%
45%
25%
0%
20
19
17
14
9
5
0
Example: Acme's Score
Category
Quality
Delivery
Technology
Support
Total score
Points awarded
Month ending 12/31/92
Total cost per item per dollar purchase = [(100 - 92)/100] +1 = $1.08 total cost factor
Adjusted cost per unit = Price
X
total cost factor = $10.00 unit
X
1.08 = $10.80/unit TCO
25
19
30
18
__
92
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estimates of future costs. Value-based models tend to focus on a small number
of major cost issues, generally around three or four. Calculations beyond this
point tend to become too complex.
Not all of the case study organizations converted their TC analyses into
unitary or some other type of cost. Six of the cases specifically used TC analysis
data to develop cost per unit data. Three used a dollar-based TC analysis to
develop total cost savings from a process change rather than looking at
individual product/service costs. Two used a value-based combination of cost
and weighting factors to develop a total “score” which, although based on total
cost calculations, was not converted into dollar savings.
The relative advantages and disadvantages of the TCO approaches are
shown in Table II. The primary uses of each type of model by the case studies
is shown in Table III. All of the case study organizations acknowledged and
discussed the advantages and disadvantages of the approach they had chosen
for TCO analysis. Perhaps the major issue in developing a TCO approach was
the trade-off between an approach that was easy to use, and one that was
complex and flexible enough to capture key issues. The selection of the
approach to TCO was made based on a number of factors, including the types
of decision the organizations would be using TC modelling to support.
In all of the case study organizations, the TC analysis results were used to
support decision making rather than flowing to the organizations’ financial
statements. Northern Telecom has a goal of using its model for product/service
valuation in the future. This is contingent on implementation of an organization-
wide approach to activity-based costing and total cost modelling.
Table II.
Comparison of relative
advantages of dollar-
based and value-based
TCO models
Model advantages Disadvantages
Dollar-based – direct cost
Tailor factors considered to decision Time consuming
Very flexible Does not make sense for repetitive decisions
Alter level of complexity to fit decision Not cost beneficial for low dollar buys
Help identify critical issues
Dollar-based – formula
Easy to use once system is in place Time consuming to establish system
Excellent for repetitive decisions where costs Formulae need to be periodically reviewed
for key factors can be determined and updated
Inflexible to different types of decisions
Considers a limited set of factors
Value-based model
Can incorporate issues where costs cannot be Time consuming to develop; only good for
determined important and/or repetitive decisions
Considers the importance of factors using Much judgement in establishing
weighting weightings
Easy to use for repetitive decisions
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Unique versus standard models
The organizations studied tended to use unique models that are specially
developed for each buy. These models may share a common set of total cost
factors, such as quality, delivery and service. But the data need to be separately
developed for each buy. Organizations chose to use a unique versus a standard
type of model for a number of reasons, as shown:
●Factors which favour a unique model: buys to be considered vary greatly;
no one set of factors captures critical issues across buys; desire for
flexibility in cost modelling (adapting to user needs, adapting to various
buys, adapting to changes in internal focus).
●Factors which favour a standard model: issues of concern are same
across buys; desire for user-friendly/relatively easy to use model; desire
to computerize the system; desire to analyse repetitive purchases.
The key factor which determined the choice between a unique and a standard
TCO model was the type of buy to be considered (see Table IV). In instances
where an organization desired to analyze repetitive buys, or buys where the
same cost factors were of primary concern across buys, a “standard” model
was developed. This was the case for Northern Telecom, Texas Instruments
and the SEMATECH capital model.
The remaining models studied were unique. Some TCO models were
developed to support a particular commodity and would be used repetitively
for evaluation or selection over the life of that commodity. Other models were
developed for a one-time buy or for a long-term decision, and would not be
specifically reused. The latter was particularly true in make/buy or outsourcing
decisions.
Table III.
Primary uses of various
types of models among
case studies
Type of model Primary uses
Dollar-based – direct cost Supplier selection
Supply base reduction
Make versus buy/outsource
Process improvement
Dollar-based – formula Supplier volume allocation
Supply base reduction
Ongoing supplier evaluation
Process improvement
Value-based Supplier selection
Make versus buy/outsource
Process improvement
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Comparison of the two TCO approaches
Based on previous research[13], the classification of TCO model type by
primary model use has been expanded, as shown in Figure 3. The models are
further classified as to whether they are standard models (basically the same
costs considered for each buy, with a standard format) or unique (a new model
developed for each buy) and by type of buy, also known as buy class. All of the
organizations that use a TCO model primarily for supplier evaluation also use
it to some degree for selection. This figure provides some interesting insights.
Two of the firms which use TCO models primarily for evaluation use
standard models. This is logical, given that these models will be used
repetitively for tracking and reporting supplier performance and
communicating performance information to suppliers. The third organization,
Shell, has a standardized format it recommends. However, the cost factors
considered are unique, based on their relative importance to that purchase.
Thus each model is unique.
All of the users of standard evaluation models share TCO data with their
suppliers. Standardization makes the models easier to maintain. In addition, if
the TCO model format and content were changing, the supplier would probably
find the model output less useful. Thus, some sort of standardization of
evaluation models seems prudent. Further, since Northern Telecom and Texas
Instrument’s TCO models are based on ABC principles – which require a great
deal of work to set up – it seems wise to standardize them from a resource usage
standpoint.
Most of the TCO models used primarily for selection are unique. The
exception is the model used for production capital. The case study firms use
fairly standardized models for production capital because the issues – yield, up-
time, maintenance, and so on – are relatively constant across production capital
buys. All of these organizations use the standardized SEMATECH capital
model or some variation of it.
Table IV.
Determination of
whether to use
standard or unique
models
Non-repetitive buys Repetitive buys
Type of buy
Productive capital Major acquisitions, Supplier selection Ongoing supplier
make-buy or with no or ad hoc performance monitoring,
process analysis updates perhaps selection
Recommended TCO approach
Develop a relatively Develop a unique Develop a standard Develop a standard
standard model for model which fits model that can be computerized model
capital which can that buy, and can be used across buys, that is automatically
be adapted for updated to evaluate manual or updated monthly or
other capital actual performance computerized quarterly, can be used
purchases versus estimate across buys
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The standard MRO and component models used by Texas Instruments and
Northern Telecom were developed as computerized systems. Their models
follow the same format for both components and MRO. Model standardization
was necessary in order to have the model extract data directly from the firms’
sophisticated computer networks. The models are used for high volume,
repetitive buys which have relatively standard TCO elements affecting them.
Both Texas Instruments and Northern Telecom developed these models
primarily for ongoing supplier evaluation, and currently use them for supplier
selection and volume allocation where they have experience with a supplier.
The remaining selection-focused models are unique, representing the fact
that the case study firms believe that each supplier selection decision is unique.
Figure 3.
Cross classification of
major TCO model use
Value-based Dollar-based
Primary use Standard Unique Standard Unique
S
E
L
E
C
T
I
O
N
E
V
A
L
U
A
T
I
O
N
Production
capital W, Z SEMATECH,
TI, SPS, Intel
Operating
capital W,SPS Intel
MRO SPS, Z Intel
Components W,
GSTG
SPS
Intel
Materials W, SPS Intel
Service GSTG,
SPS, Z Intel
Production
capital Shell
Operating
capital Shell
MRO Shell TI
Components Shell NT, TI
Materials Shell NT, TI
Services Shell
Process
re-engineering Firm X, Y
SPS
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While building unique models creates more work, it also gives the process more
credibility and flexibility to respond to user needs and changing market
conditions. Because the users of unique TCO models employ such models only
for supplier selection of crucial items, the burden of model creation is not as
great as it might otherwise be.
Intel is the only one of the six selection-focused firms, excluding
SEMATECH, to use dollar-based TCO models. Since it is based on actual costs,
dollar-based TCO is relatively easy to explain to other members of the
commodity team. The remaining firms use a value-based approach. A possible
rationale for this will be discussed in the next section. Organizations which use
TCO primarily for process re-engineering use unique models, since each
area/process analysed is unique. These organizations also use dollar-based
models to reflect their actual past or projected future expenditures.
TCO model for selection and evaluation
Supplier selection and supplier evaluation are closely related activities. The
former relates to choosing the supplier for the right reasons. The latter relates
to maintaining a relationship with that supplier over time and helping the
supplier identify improvement opportunities as long as it still makes sense to do
business with that supplier. This section discusses the finding that using TCO
for both selection and evaluation in the same organization appears to be the
exception rather than the rule. It further discusses the benefits of integrating
supplier-selection and supplier-evaluation models.
TCO selection/evaluation modelling in the same firm
Only four case study organizations use a total cost of ownership approach for
both supplier selection and supplier evaluation. The firms include all three
firms that use TCO primarily for ongoing evaluation – TI, NT and Shell – and
one firm that uses TCO primarily for selection – Motorola SPS. Shell and
Motorola SPS use unique models, while NT and TI use standardized models.
Motorola SPS uses a standard TCO model to track ongoing supplier
performance and allocate volume among suppliers for one crucial raw material.
However, they do not utilize that model in making supplier-selection decisions
in the same buy class (raw materials) or other buy classes. This supplier-
evaluation model is unique to that particular purchased item, while “standard”
for that item over time. Thus, although Motorola SPS routinely uses TCO for
supplier selection, TCO is used for evaluation only on an exceptional basis.
Thus, this firm’s TCO modelling may not be indicative of that of other firms
desiring to use TCO for both supplier selection and supplier evaluation.
It is interesting to note that Motorola SPS originally implemented TCO for
ongoing evaluation of the particular raw material mentioned above. It began
with a value-based approach. When it expanded TCO for use in supplier
selection, it followed most of the other selection-oriented case study firms in
using a unique approach for each buy. It did not, however, switch over to a
dollar-based approach like most of the other case study firms. While the
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number of cases reviewed is too limited to draw conclusions, the type of model
with which a firm begins its TCO efforts may have implications when it
expands TCO usage.
Commonality between selection and evaluation models
Both the selection model and the evaluation model provide excellent transaction
cost data for reducing the supply base or for allocating volume among
suppliers. Indeed, both selection-focused and evaluation-focused firms use their
TCO models for this purpose. The evaluation-focused case study firms use
TCO data for supplier selection in that they may use such data to allocate
volume among suppliers or to reduce the supply base. However, this is quite
different from using TCO data to analyse new suppliers.
Both selection-focused and evaluation-focused TCO firms also use their TCO
data for communicating priorities to suppliers and driving supplier
improvements. They use TCO for process re-engineering at a more functional or
micro-level than do the two firms which focus on process re-engineering as the
driver of TCO. By using TCO at a micro level, they tend to focus on
improvements in the purchasing area or at the supplier’s end, rather than on
broader, corporate-wide issues. Both sets of firms use TCO data for negotiation
purposes, which may be closely related to driving supplier improvements.
Thus, there are some definite commonalities between selection- and evaluation-
focused TCO approaches. The next section discusses how to give leverage to
these synergies.
Importance of a TCO model for both selection and evaluation
While TCO is a philosophy that involves evaluating suppliers and purchases on
a basis beyond price, in execution TCO is a model. TCO models provide a
snapshot of supplier performance at a point in time. If historical data are limited
or unavailable, as in the case of a potential new supplier, TCO provides data
regarding expected performance, based on estimates and externally gathered
information. Thus, regardless of whether it is cost based or value based,
selection focused or evaluation focused, TCO is an evaluative tool.
Using total cost of ownership to select a supplier can be compared to
interviewing a prospective employee. The interviewer knows what the
organization is seeking in terms of qualifications and what the job duties are.
The post should be filled with the best available candidate. Likewise, in
performing a TCO analysis for supplier selection, the supplier’s qualifications, in
terms of cost elements, are determined. The firm knows how the supplier will be
required to perform to meet the firm’s needs. Thus, the best supplier is selected
based on the right combination of low TCO and ability to perform additional
“duties”, such as special delivery requirements, lead times, and so on.
In order to understand and improve on performance, an employee requires
feedback. After an employee has been working for an organization for a certain
period of time, she or he usually receives a performance appraisal. This gives
the employee performance feedback regarding strengths and areas to improve
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on. An appraisal also verifies whether the hiring decision was a good one.
Performance appraisals continue throughout the employee’s career, to ensure
that she or he is still doing well and supporting the company’s goals. If the
employee is not performing, improvement tactics are implemented, or the
relationship is terminated.
Likewise, a firm should continue to evaluate suppliers on an ongoing basis.
As discussed in the transaction cost analysis literature, the potential for
supplier opportunism exists; thus ongoing evaluation of the relationship is
required[27]. The firm invested time and effort in choosing the right supplier.
Does it not make sense to verify whether the supplier is meeting expectations?
Might it not be valuable to give the supplier feedback regarding strengths and
areas for improvement? Might it not also be wise to keep the supplier informed
of the firm’s goals and expectations, and of how the firm perceives the supplier
to be performing against those goals and expectations? How can the supplier be
expected to improve without such dialogue? Generally, unless priorities have
changed, the supplier should be evaluated based on the same criteria that were
considered when the supplier was selected. If that is not the case, the supplier
selection model is not looking at the “right things” initially. The two
organizations that use unique TCO models for selection and evaluation
specifically develop one model that can address both issues.
The employer-employee situation can be extended from the standpoint of
using TCO for evaluation, but not selection. That is analogous to hiring
someone without a proper interview, then hoping that she or he can perform the
job duties. Assessment would be made at his or her performance evaluation. If
a supplier is selected using a model other than TCO, that is akin to hiring
someone based on one set of qualifications, but evaluating his or her
performance based on another set. Either way, it does not make good business
sense. The selection and evaluation processes are inherently linked. A firm’s
own internal hiring processes and supplier management processes should
reflect this relationship.
Recommendations
Based on the results of this study, TCO represents an excellent means to
improve supplier selection and evaluation. TCO analysis provides valuable data
for improving supplier performance, focusing on and negotiating the cost and
performance issues that are of most value to the firm, and monitoring supplier
performance over time. As such, TCO represents a valuable tool and philosophy
for firms to adopt in understanding supplier-related transaction costs. If
competitors in an industry are using such an approach, the organizations not
using TCO are at a disadvantage in terms of their supplier and purchased
item/service knowledge[12,16].
Neither the dollar-based nor the value-based approach to TCO modelling
appears to be superior to the other. Likewise, there is no evidence to support
that it is better to use TCO for supplier selection than for evaluation, or process
re-engineering or vice versa. In developing and implementing TCO, the best
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approach is to plan the process, assess what TCO will be used for, and focus on
the benefits the firm desires[11]. This is precisely what TI and NT did in
developing a TCO approach to support both selection and evaluation. The
major weakness of their models is that neither is useful for selecting new
suppliers.
Two of the major reasons for TCO analysis among the case study firms –
supplier selection and supplier evaluation – should work together to benefit the
firm. Keeping in mind that TCO modelling is performed on only a limited
number of selected items by all of the case study firms, developing a system to
focus properly on both selecting and evaluating key suppliers using TCO is not
unreasonable. The data derived from these models can be used to support or
highlight opportunities for process re-engineering.
Whether the firm desires to use a standard or a unique approach for each
item will vary with the firm. The researcher recommends that once a model is
in place for a particular item, that same model should be used to the greatest
extent possible for all supplier selection and evaluation decisions related to that
item. This will provide consistency over time for both internal and external
communication concerning evaluation and selection. As discussed previously, if
process re-engineering is the primary goal of TCO analysis, a unique model is
required to reflect the process being analysed.
The researcher strongly recommends the use of standardized models
whenever they are viable. If the model can be extended to all items in that buy
class, or slightly modified without distorting decisions, all the better in terms of
work load. However, the integrity of the results should not be sacrificed simply
to use an existing model. When a standard model will not fit the situation, an
approach recommended by the author, based on Shell and Firm W, is to have a
standard listing of major total cost elements common to model builders/users.
These can be chosen based on their relevance to the situation and the
availability of data. Methods for calculating the costs and/or sources of data
should also be made available to simplify the procedures.
When considering a new supplier, where internal data are unavailable, one
selection-focused firm projects the new supplier’s cost performance on the
unknown element to be the same as the worst performing current supplier. The
reasons behind this approach are: first, the conservative convention, that it is
generally preferred to have a new supplier perform better than expected, rather
than worse; and second, there are always costly and unexpected issues with
adding a new supplier. A high cost for unknown elements helps cover those
issues.
Organizations that are currently using TCO only for evaluation and not
selection, or for selection and not evaluation, should modify their approach.
Combining the benefits of TCO analysis for both supplier selection and supplier
evaluation should prove to be a powerful, competitive tool and communication
tool. Regardless of the type of supplier selection or evaluation system currently
used in a firm, the selection and evaluation systems should be linked, using the
same criteria and consistent rating scheme.
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Using a common model for both supplier selection and evaluation has many
benefits. First, the linkage provides focus and a consistent message about what
is important to both suppliers and internal users. Second, using a common
model will create less work, confusion and training requirements than would
different models. Third, the outcome of selection/evaluation can be used directly
to pre-qualify suppliers, qualify suppliers, and even be part of the supplier
certification process. Thus, all of the firm’s supplier measurement tools will be
linked and consistent.
Summary and conclusion
This article makes a contribution to purchasing and logistics theory and
practice in a number of ways, first, by showing the linkage between TCO and
understanding total supply chain costs, purchasing costs are highlighted as a
crucial element of total supply chain costs. The principles advocated here can be
used to understand and evaluate better any link in the supply chain, as well as
total supply chain costs. Second, this article establishes a theoretical framework
for TCO analysis by linking it to transaction cost analysis in the economic
literature. Third, by comparing TCO to other purchasing frameworks,
differences are explored, deepening the understanding of the benefits of and
barriers to TCO. Third, different TCO methods (cost- and value-based) are
compared based on organizations that use TCO. Examples of TCO models are
included. The rationale behind using unique versus standardized TCO models
is also discussed.
As TCO continues to evolve, and more firms implement a TCO approach,
research is needed to explore how companies link their supplier-selection and
supplier-evaluation models. It would be beneficial to other firms to know if the
linked models are generally standard or unique and dollar based or value based.
If there is a pattern, can the firms explain their model choices? Further, as firms
expand their TCO modelling efforts from selection to include evaluation, or
from evaluation to include selection, what issues do they face in modifying
current models? Are their new TCO models largely a function of their existing
TCO models, or are major changes required? Clearly, there exists a wealth of
opportunity for continued research into the use of TCO modelling in
purchasing and understanding supply chain costs.
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