Gartner Research

Use Total Cost of Ownership to Optimize Costs and Increase Savings

Published: 19 January 2018

ID: G00344949

Analyst(s): Miguel Cossio

Summary

Reducing costs is often top of mind for supply chain leaders in sourcing and procurement, yet a narrow focus on unit price alone can lead to increased supply chain costs. Use this research to identify different types of cost that can be optimized to ensure savings accomplished hit the bottom line.

Overview

Key Challenges
  • Total cost of ownership (TCO) is hard to implement, as sources of costs will vary across different spend categories.

  • Implementing TCO is a resource-intensive initiative with limited use cases, resulting in poor adoption by the sourcing and procurement organization.

  • Organizational silos and financial reporting structures make it hard to report cost savings obtained beyond unit price.

Recommendations

To improve sourcing and supplier management operations and performance:

  • Identify areas of opportunity to implement TCO based on data availability and potential cost savings.

  • Drive adoption of TCO by incorporating it into foundational sourcing processes such as supplier selection, contract negotiations and performance management.

  • Raise awareness of the value delivered by the sourcing organization by communicating savings obtained through TCO regardless of what is commonly reported to the rest of the organization.

Introduction

Reducing cost is often a priority for companies operating with thin margins or where material costs are a significant portion of their price structure. While unit price is important, there are multiple costs incurred when sourcing from external suppliers that are often overlooked by leaders in sourcing and procurement.

It is too easy, and often a mistake, to focus exclusively on negotiating with suppliers for a lower cost. While this may lead to short-term savings, it can also result in an overall cost increase due to added supply chain complexity and other "hidden" costs. For example, U.S. buyers shifting supplier production from a local manufacturing site to Asia may report cost savings, yet fail to account for additional logistics costs in expedited freight needed to cover demand fluctuations.

The concept of total cost of ownership (TCO) refers to capturing all associated costs incurred by a buying organization when purchasing goods or services from external providers. This is an essential input to effective cost-to-serve analysis, which helps quantify the cost/service trade-offs associated with varying levels of complexity in how your supply chain supports customers and products in your portfolio.

While TCO is not new, Gartner sees poor adoption of this critical concept by supply chain leaders in sourcing and procurement. TCO is an essential tool that helps ensure that the cost savings obtained in supplier negotiations are reflected in the bottom line, and not simply transferred to other areas of the organization. Companies looking to optimize costs should evolve from a myopic focus on unit price to an end-to-end assessment of all the sources of costs that are incurred by doing business with their suppliers.

A common analogy of the total costs incurred in a purchasing transaction is shown in Figure 1, where unit price is considered the tip of the iceberg compared to other "hidden" costs that an organization may incur when sourcing from an external partner.

Unit Price in Relation to Other Associated Costs

Shifting toward a TCO model is hard to implement, yet not impossible. As shown in Table 1, there are multiple challenges and benefits of moving beyond unit price. One thing is certain: every dollar saved increases shareholder value, regardless if it was obtained through lower unit price, reduced freight or better working capital conditions. Rather than limiting the definition of "procurement savings" to unit or invoice price, sourcing leaders should focus on (and get credit for) all cost optimization efforts that result in an overall cost reduction for the organization.

Analysis

Identify Areas of Opportunity to Implement TCO Based on Data Availability and Potential Cost Savings

There isn't a universal definition of TCO that can be applied across industries. The concept of TCO will vary greatly depending on the industry, spend category and internal processes that are performed at the buyers' versus suppliers' operations. This can present a challenge for organizations looking to adopt TCO. However, it also provides flexibility around how TCO is defined and used in each organization.

The purpose of implementing TCO is simple — understand, control and optimize as many costs as possible that are incurred by the buying organization across its multiple categories of spend. A practical approach for identifying associated costs is shown in Figure 2, where a noncomprehensive list of costs is shown under three main categories: acquisition costs, operating costs and disposal costs.

Cost Type Categories and Examples

A common focus of the sourcing organization has historically being on costs associated in the acquisition process. Taking a step back and recognizing the different sources of cost can uncover a variety of ways that these can be optimized to deliver additional savings. Companies currently using a total landed cost (TLC) approach are one step ahead in the process. However, significant opportunities exist beyond TLC that should be explored.

Cost optimization opportunities for these "hidden" costs, beyond TLC, will vary greatly depending on spend category type. For example, an industrial manufacturer buying steel coils used in their stamping operations will likely look at scrap or process yield as an opportunity to reduce cost. In contrast, the same manufacturer buying printed circuit boards to assemble in a final product might omit internal yield as part of their cost model and focus instead on warranty claims from its end customers.

Moving toward a TCO model is a journey that organizations embark upon based on data availability and opportunity areas identified. To get started, answer the following questions:

  • Where are we traditionally focused when looking for cost savings?

  • Based on the three categories of costs shown in Figure 2, which additional costs can we start focusing on based on data availability and cost impact?

  • What information do we need? Where will this information come from?

Based on the answers to these questions, consider the different cost categories presented in Figure 2. Take necessary steps to incorporate as many "hidden" costs as possible into the TCO model for each spend category. It is likely that this information will come from different silos of the organization, which will require leaders in sourcing and procurement to reach out to different stakeholders to socialize the TCO initiative and request their support. In some cases, it may be easier to obtain key information to calculate those costs directly from the supplier base. For example, when trying to calculate the freight costs at the part number level, getting packaging information such as parts per pallet and pallets per container load may be easier to obtain directly from the supplier rather than from internal functions.

Remember that TCO is more art than science, and multiple definitions of what is included in TCO calculations will exist even within the same organization depending on the spend category. However, the main goal remains the same — identify and work to reduce as many costs as possible.

Incorporate Total Cost of Ownership Into Sourcing Processes

Implementing TCO is a resource-intensive process where data from multiple sources will be needed in order to gain insight into all costs associated in each purchasing transaction. Supply chain maturity plays a significant role in an organization's ability to adopt TCO, as it requires cross-functional integration and data visibility across the enterprise. (See )

In order to be successful in its implementation and keep it relevant, leading companies incorporate TCO into their everyday procurement processes such as:

  • Supplier selection: Category-specific TCO models are used to compare supplier offers based on price, freight, warehousing, taxes, duties and working capital, among others. For example, moving supplier spend from a local supplier to a foreign one, will not only have an impact on freight and import duties, but also on increased inventory needed to support production fluctuations and longer delivery lead times. With a simple TLC comparison of both supply options, moving the business to the foreign supplier may seem like a good option. However, factoring additional considerations (such as warehousing costs, the impact to working capital and the lost flexibility to meet customer demand), might present a different scenario. In this case, keeping a local supply may be the best option, even if at an apparent higher unit price.

  • Contract negotiations: Using TCO as part of the contract negotiation process provides a powerful tool that buyers can use to obtain more favorable conditions. Rather than negotiating unit price alone, buyers may shift their focus to other sources of costs that have been traditionally ignored in the past. For example, an industrial manufacturer was able to negotiate better terms with an already-competitive supplier by discussing costs incurred in expedited freight and internal quality rejections at its assembly lines. Being armed with greater information on all costs incurred with your supply base provides a powerful negotiating tool that can be used to obtain greater savings.

  • Performance management: One of the most critical aspects needed for successful adoption of TCO is including it on both internal (staff) and external (supplier) performance assessments.

  • Leaders in sourcing and procurement are often measured on cost savings based on unit price alone. Even if total landed costs are being used as part of the supplier evaluation and selection criteria, most organizations will only consider unit price savings as part of the results delivered by the sourcing function. Regardless of the reason behind this, significant cost optimization opportunities are often overlooked by sourcing leaders, simply because there isn't an apparent benefit that will reflect on their reported results. Incorporating all accomplished savings, regardless of its source, enables sourcing leaders to make the right decisions and ensure reported savings hit the bottom line versus costs being transferred to other functions.

  • Incorporating TCO into supplier scorecards presents a great opportunity for both buyer and suppliers alike to focus on optimizing costs across the life cycle of the products being purchased beyond unit price. With this broader view, both parties can search for savings opportunities that may result in changing delivery terms, packaging or even material specifications to eliminate waste in the supply chain. Implementing TCO in supplier's cost performance promotes supplier innovation as well, as now they are credited with cost improvements beyond unit price.

Using TCO as part of the supplier selection process and contract negotiations allows leaders in sourcing and procurement to make better, informed decisions. However, it is important to keep in mind that not all costs included in TCO will be recurring, with some being incidental. For example, consider expedited freight costs incurred with a supplier. While it should be part of the cost conversation with the current supplier, it should not be used when comparing to another supply source. The reason being that it is impossible to predict if similar expediting costs will be incurred with the new supplier and wrong assumptions may not lead to the desired result.

Showcase Savings Regardless of What Is Reported Financially by Procurement

The two most common excuses, that we hear from sourcing and procurement leaders, for not adopting TCO are:

  • "Sourcing metrics are based only on unit price."

  • "Other savings obtained such as freight, warehousing and scrap reduction are reported in separate cost centers. We don't have the time to discuss who gets the credit for these savings with other functions."

In response, we advise that sourcing and procurement leaders' focus should be on cost optimization, not simple cost reduction. Cost optimization is a business-focused approach to reducing total cost of ownership across the end-to-end supply chain while maximizing value to the business.

Leaders in sourcing and procurement struggling with this "ownership dilemma" should implement TCO, regardless of what is reported financially to the rest of the organization. Implementing TCO into sourcing activities and performance management will ensure that the right, informed decisions are being made. When communicating results, make sure to identify the multiple categories where costs are being optimized in addition to unit price. This will elevate the role of sourcing and procurement in the organization by showing other functions the value that the sourcing organization is delivering, and how savings are not simply being transferred to other parts of the supply chain.

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