A Guide for Managers to Understand Total Cost of Ownership (TCO)
In the world of big business, the concept of Total Cost of Ownership (TCO) is important for both buyers and sellers alike. As a buyer, the initial cost of acquiring the product may be relatively small when compared to the annual cost for the maintenance and support of the product. Effective managers research their products in order to establish an understanding of the expected total cost of ownership over the life expectancy of the offering. As a seller, your clients will typically compare your offerings versus competitors from a Total Cost of Ownership perspective. Top salespeople understand their client's concern over TCO and incorporate this into their proposals in order to assist the buyer in the evaluation process.
Basics of Total Cost of Ownership
By design, Total Cost of Ownership (TCO) is a calculation designed to help people make more informed financial decisions. Rather than just looking at the purchase price of an object, TCO looks at the complete cost from purchase to disposal including expected costs to be incurred during the lifetime of the product, such as service, repair, and insurance. TCO is factored into the cost-benefit analysis.
Total Cost of Ownership Is Not New
Although TCO is often referenced in connection with Information Technology (IT) the concept has been around since the 1950s and 1960s when it was regularly discussed in the elevator industry. Some experts believe the concept (if not the term) dates back to Napoleon’s time when "engineers began to pay very close attention to issues like the effectiveness of cannons and how easily they were moved and repaired, and for how long they lasted in active service."
Total Cost of Ownership Varies by Industry
The additional costs that must be added to the initial purchase price to calculate the total cost of ownership (TCO) vary by industry:
- Information Technology Hardware. TCO has been used extensively in the acquisition of information technology hardware. Estimates for the TCO of hardware typically estimates the cost for out-of-warranty repairs, the cost of annual service agreements, and the prorated cost of additional hardware and software required to leverage the hardware. As the number of web service providers continues to increase, more and more IT firms lease space from these providers, thus eliminating large investments in hardware and, consequently, reducing the annual costs and the TCO incurred for running a firm's software applications.
- Traditional Software Licensing. For much of the history of the software industry, licensing was purchased based on an initial cost (or license fee) plus an annual software maintenance fee which was calculated as a percentage of the original license fee. Initially, this annual maintenance agreement included bug fixes and feature upgrades when available. However, this type of perpetual licensing has lost popularity in favor of subscription-based licensing whereby the client re-purchases the right to use the software on an annual basis.
- Automobile industry. Edmunds.com has a TCO calculator that adds depreciation, interest, taxes and fees, insurance premiums, fuel costs, maintenance, and repairs to the purchase price of a car or truck.
- Financial industry. Many mutual funds and similar products charge quarterly management fees and/or have withdrawal charges. These indirect costs must be considered when calculating the true cost of these investments.
Considerations for TCO Calculations
Consider the following nuances when attempting to understand the TCO of an offering:
- Hidden costs are always a concern. For example, a new software package might require initial training for users and supplemental training for new users moving forward.
- The method of financing will impact the total cost of ownership and the accounting treatment for deductions, capitalized expenses, and depreciation which will impact a detailed TCO calculation. Be sure to work with your accounting or finance department to ensure you have a complete picture of all of the implications (and costs or deductions) associated with your purchase.
- Don't forget labor costs. You may gain efficiencies from new investments, thus reducing overall operating costs. The benefits from these efficiencies may actually defray or outweigh, the actual costs. Conversely, you may incur additional labor costs as a result of the investment.
- Total Cost of Ownership often changes over time. Logically, your annual repair costs for an automobile will rise as it ages, as will the cost of servicing the car based on inflation. Make sure you factor in expected changes in costs over the lifetime of the vehicle.