Calculating The Total Cost of Ownership For Items Which are Inventoried

BY MARY LU HARDING, C.P.M., CPIM, CIRM

otal cost of ownership is an assessment of all costs involved with an item over its useful life. Typically, it is calculated at the beginning of the purchase process to determine the most cost-effective choice. At this point, many of the costs included are estimates, since they have not yet been incurred. Calculating the total cost of ownership can give an organization better information with which to make the purchasing decision. Many purchasers know instinctively that quoted price is not the only cost that will be involved in obtaining and using an item. Inclusion of all other known cost factors allows a more complete picture to emerge. Many cost factors are known only to users or others in the organization. The most complete picture will be compiled by a team composed of purchasing plus at least the users, technical experts and finance. Insuring that all involved parties have the chance to participate is important to achieving a useful result. Define the ground rules and assumptions which will guide the work, including: I Definition of what is needed and who will use it I Estimate of how long the item will be in use I Assumptions for quantities or consumption rate I Definition of the process for defining the areas of cost to be included I Definition of the process for calculating cost figures for these areas I Estimates of cost elements (such as the cost of carrying inventory) The elements of cost will be different for inventory or stocked items versus capital equipment. Inventoried items are of lower dollar value per unit, but higher volumes. Inventory items also are moving through the business. They are regularly turned over. Capital equipment is stationary and may be in place for a long time. Typical areas included in the total cost of ownership for each of these include:

How to approach calculation of the Total Cost of Ownership:

The steps in determining the total cost of ownership are: 1. Form a team composed of purchasing, users, technical experts and finance. Add others as appropriate. 2. Define the ground rules for the process and the assumptions listed above. 3. Define the areas of cost that the team believes are relevant to this purchase or item. 4. Work out reasonable methods for calculating costs for the areas you have identified. Calculate those costs. 5. Sum all relevant costs. Make your decisions based on calculation of the total cost of ownership. Total cost of ownership data is typically used to make a better choice of suppliers or of items to be purchased. It compares Supplier A to Supplier B or Item X to Item Y. If the calculations are used for relative comparisons, you can be somewhat more relaxed in determining costs. Estimates are acceptable as long as they are relatively valid. In other words, they provide a valid basis for comparison. Two criteria are important when calculating relative costs: 1. That the formula makes sense. It is relevant to the issue and can be calculated. 2. That the formula can be applied across suppliers and used to validly differentiate them If total cost of ownership is used to make capital allocation decisions, then there will be more stringent restrictions on assumptions and more urgency to use only verifiCAPITAL EQUIPMENT Structure of payments over time Packing & crating costs Cost of transportation Cost of site modifications Cost of rigging & installation Technical assistance at start-up Operator training Cost of service & maintenance Cost of supplies and spare parts Trade-in value of old equipment Estimated useful life of new equipment

INVENTORY Cost of non-delivery Cost of non-quality Cost of transportation & packaging Cost of carrying inventory Production-related costs Administration costs per part number Availability / flexibility Technical assistance

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able dollar figures. Numbers will be required to be absolutely accurate, not just relatively accurate. The degree to which you can use relative versus absolute cost data should be defined as one of the starting assumptions. Ownership costs can be divided into three categories: incurred costs, performance costs and policy costs. Incurred costs are ancillary charges for which you will be billed (i.e. transportation, spare parts, set-up charges). Incurred costs can be determined to a reasonable degree of absolute accuracy. Performance costs include issues such as delivery performance, quality and requirements for service or maintenance. Performance costs are relative data. As long as it is valid for relative comparison, it is less important that it be an absolute cost figure. Policy factors are also relative. They encompass any issue that your organization chooses to incorporate to reflect political or social policy directives. Issues such as recycled content of materials, minority and women-owned suppliers and political preference fall into this category. Typically a supplier or item either does or does not meet the policy criterion. The factor is a yes / no factor, and establishing a dollar value for it rests with the policy makers within your organization.

Total Cost Factors for Inventory Materials:

The following issues are typically included in the total cost for items to be inventoried: Cost of Non-Delivery. You bear additional costs for a supplier's failure to deliver on time. If the supplier delivers early, you will pay for the goods sooner and carry the inventory longer. If the supplier delivers late, you will consume people's time to replan the materials schedule and/or expedite the delivery. If the lateness is chronic, you may carry safety stock. Cost of non-delivery is a performance cost factor. As long as the measure is valid for relative comparison, it does not have to reflect actual dollars incurred, which can be variable and would be difficult to calculate for each situation. A simple method to incorporate the cost of non-delivery into total cost calculations is to use the non-delivery performance percentage as a price adder. For example, if Able Company delivers on time 85% of the time, then they are not on time 15% of the time. Multiply Able's quoted price by 15% and add that amount to the base price as a cost factor for non-delivery. The better the delivery performance, the lower the cost factor. Since each supplier bears the cost factor relevant to its own performance, it is a fair way to differentiate between suppliers based on their performance. Cost of Non-Quality. The cost of non-quality includes the overhead expense of an incoming quality inspection, a reject-materials stockroom, the administrative expense of a materials review and the material return. If your organization uses activity-based costing, then the cost 22
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of quality may be an identified cost pool. In that case your organization will have a good idea what those costs actually are, and you can apply known numbers to the total cost of ownership based on the proportion of the total resource consumption that the item represents. If you do not have actual cost numbers, you can use the measure of percent defective items as a price adder. For example, if 8% of Baker's material is rejected, then Baker's price is multiplied by 0.08 and that amount is added to the base price to compensate for your costs of handling non-quality goods. The higher the supplier's quality, the lower the cost factor, and since each supplier bears the cost factor relevant to its own performance, it is a fair way to differentiate between suppliers. Cost of transportation. If you pay for freight, it should be included in total cost. To determine transportation costs, obtain the invoice amounts (either from the supplier's or the carrier's invoices) for several typical shipments. Add these costs and divide the total cost by the total number of units shipped. This will give you the transportation cost per unit. Cost of Inventory. Keeping inventory is expensive. Money is consumed paying for it which could be spent elsewhere. Inventory consumes more money just sitting on the shelf. The cost to carry inventory normally includes the interest rate of money, insurance, taxes, space and obsolescence reserve. Most corporate inventory carrying costs are based on these factors alone, and the numbers are typically 20-30% per year. Unfortunately, basing the cost of inventory on those factors alone misses other areas of cost which are less easy to calculate but very real. Additional areas of cost include personnel (whose function is inventory management / movement, such as warehousers, or inventory controllers), an appropriate allocation of computer systems costs, storage and handling equipment (such as forklift trucks and racking) and material losses / rework due to handling damage or induced quality problems. If these additional costs are included, the cost of inventory grows to more than double the commonly used figures. Inventory carrying cost becomes a significant factor in the total cost of ownership when new items are being added or when choice of supplier will have different inventory implications (such as a choice between a domestic versus an international supplier or between any two suppliers with significantly different lead times). To include inventory costs into the total cost of ownership, determine your annual cost to carry inventory (percentage). Divide that percentage by 52 to determine the carrying cost per week. Multiply this number by the number of weeks of inventory you keep on hand. This gives a percentage that can be used as a cost adder in the same manner as other performance percentages. (Multiply the price by the percentage and add the result into the total cost.)

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Use-related costs. This category includes ease of use, effect on final output, ability to automate or any measurable effect that the item would have on the process in which it is used. Time factors can be translated into total cost factors by multiplying the difference in time between the alternatives by the labor rate of the people involved. The resulting cost difference can be applied to the total cost of ownership. Lead time can be included as a total cost factor if you want to reduce lead times or if they differ between suppliers. Lead time can be factored into total cost as a percentper-week. Establish a value that reflects the degree of emphasis you want to place on reduction. Start with 1% per week of lead time and evaluate whether that is appropriate by comparing its weight to the other factors in the total cost profile. Credits and debits. To make a fair comparison of suppliers or items, both contributions and costs should be included. If a supplier offers something of value to you, then the "cost" of that should be calculated and subtracted from the supplier's total cost of ownership calculations. Similarly, if one item offers an advantage over another, then that advantage should be credited. An example. Figure 1 illustrates the total cost calculations used to make a selection among three suppliers: Able, Baker and Charlie. The cost factors that the customer selected as relevant include delivery performance, quality, transportation, lead time and recycled content. The suppliers also offered prompt payment discounts which were credited.

Putting it all together. Establishing a total cost of ownership process serves your organization in numerous ways. The process of selecting the criteria to be included will force the organization to become clear about what it values. This is particularly true for inventory purchases. By giving everyone in the organization access to the process, people in other functions who have a vested interest in the supply base will be free to state their concerns and define appropriate ways to represent them. The process becomes a vehicle for cross-functional education, and when done with grace results in cross-functional support. It also lends itself well to the establishment of supplier management teams. Many people in purchasing have experienced selection of a supplier in which they knew that the lowest price supplier was not the best choice. Using total cost of ownership as a means of supplier selection allows all considerations to be balanced and gives purchasing the data to justify the selection to anyone in the organization who may challenge the decision. If the criteria are collectively derived and internally public, there will be little reason to argue with the decision, even if one persons favorite supplier was not selected. Using total cost of ownership data to select suppliers results in a clearer selection process. Externally, using total cost data sends a powerful message to suppliers. Reviewing each suppliers total cost figures with them until they understand how they were calculated sends the message that it is total performance that counts not just price. Suppliers can see clearly why they are (or are not) competitive. If they did not get the business, they can also see what they have to do to improve, and more options are open to TOTAL COST CALCULATIONS EXAMPLE them than just slashing prices at the expense of performance. They can see how improving Factor Able Co Baker Co Charlie Co performance will have a direct effect on their Quoted Price $10.00 $11.50 $12.00 competitive position. N
Transport $/Qty Inventory @1.5% / wk Lead Time @2% / wk Quality % Reject On-Time Del 1 - % OT Discounts Cash Cost Save Reuse Con Total Cost ______ $15.89 ______ $16.81 +.09 (8.95/100) +1.20 (8 weeks) +2.00 (10 weeks) +1.30 (13% Reject) +1.50 (85% OT) - .20 (2% 10 Net 30) + .07 (7.00/100) + 1.04 (6 weeks) +2.07 (9 weeks) + .92 (8% Reject) +1.27 (89% OT) - .06 (.5% 10 Net 30) 0 + .18 (1 week) +1.44 (6 weeks) 0 (No rejects) +1.20 (90% OT) - .12 (1% 10 Net 30) -1.00 ______ $13.70

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