The hidden costs of TCO

Supply chain decision makers, such as transport, inventory, warehousing managers, buyers, planners, etc., are constantly comparing suppliers and solutions to choose the one that best meets their demands of various natures. And often these decisions are made under enormous deadline pressure and with incomplete information.

To help with these decisions, our main indicator is the TCO (Total Cost of Ownership) or total cost of ownership, an analysis tool for all costs involved in the acquisition and maintenance of a product, equipment or service. This index considers not only the most obvious costs of an investment, but also the hidden costs that accompany the purchase.

There is no single formula for calculating the TCO, as it can be made up of several variables depending on the nature of the acquisition. To identify which variables are these in each case, the aspects that must be considered are: acquisition costs, implementation costs, use costs and discontinuity.

Acquisition costs comprise all expenses associated with purchasing the product or contracting the service. That is, it is not just the price paid, but all other costs associated with the acquisition, for example: taxes, shipping and insurance in the case of FOB purchases. Payment terms should also be evaluated, as short payment terms generate higher financial costs such as opportunity costs and impacts on cash flow.

Deployment costs, in turn, are associated with the expenses necessary for new acquisitions to begin to be used. For example, purchasing a new raw material to replace another may require adapting equipment or hiring a specialist. Another example would be the acquisition of a fleet, which may depend on software or a team dedicated to its management. Or team training in the acquisition of new software. The structure to be mobilized to receive the product or service is an implementation cost that needs to be considered in the decision.

Usage costs include all costs associated with operating and maintaining the purchased product or service. This could be, for example, the fuel, insurance and depreciation of a fleet, the travel costs of consultants on a consulting project, the cost of updating software, maintenance costs, repair costs, spare parts costs, etc. These costs are more difficult to estimate, as they are related to the lifetime of a product or the schedule of a service, which by themselves already have a high degree of uncertainty.

Finally, we have discontinuity costs, which comprise costs related to demobilization, disposal of the product or discontinuation of the service at the end of its useful life. We could include in this category contract termination fines, staff dismissal costs, incineration of regulated materials, costs of demobilizing a construction site, costs of switching suppliers, etc.

Figure 1: Composition of TCO. Source: ILOS

As we can see, the acquisition of a product or service represents costs that go far beyond the price charged. These costs are often not clear at the time of acquisition, but they need to be unraveled so that the decision is made as consciously as possible and there are no unwanted surprises in the future. The classification of costs in acquisition, implementation, use and discontinuity helps us to identify the hidden costs of the process, but a dose of creativity and experience are also essential to predict them.

Be better prepared to identify all the hidden costs in vendor selection with online course ILOS of Procurement Processes, which deepens the concept of TCO and many others. Also, be sure to join the 26th. International Supply Chain Forum, which will take place from October 13th to 15th, completely digital and will address the challenges and practices of supplier relations and supply chain management.