Total Cost of Ownership Concept

The total cost of ownership is more than just the purchase price; other qualitative and
quantitative factors, including freight and inventory costs, tooling, tariffs and duties, currency
exchange fees, payment terms, maintenance and non-performance costs must be considered.
Firms can use total cost analysis as a negotiation tool to inform suppliers regarding areas
where they need to improve.

AN EXAMPLE

Kuantan ATV, Inc., assembles five different models of all-terrain vehicles (ATVs) from
various ready-made components to serve the Las Vegas, Nevada, market. The company uses
the same engine for all its ATVs, The purchasing manager, Ms Jane Kim, needs to choose a
supplier for an engine for the coming year. Due to the size of the warehouse and other
administrative restrictions, she must order the engines in lot sizes of 1,000 each. The unique
characteristics of the standardised engine require special tooling. This is a critical purchase
since late delivery of engines would disrupt production and cause 50 per cent lost sales and
50 per cent back orders of the ATVs. Jane has obtained quotes from two reliable suppliers but
needs to know which supplier is more cost-effective. She has the following information:
Requirements(annual forecast) 12,000 units

Weight per engine 22 pounds

Order processing Cost $125/order

Inventory carrying rate 20 % per year

Cost of working capital 10% per year

Profit margin 18 %

Price of finished ATV $4,500

Back-order cost $15 per unit

Two qualified suppliers have submitted the following quotations:

UNIT PRICE SUPPLIER 1 SUPPLIER 2

1 to 999 units/order $510.00 $505.00

1,000 to 2999 units/order $500.00 $498.00

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 3,000 + units/order $490.00 $488.00

Tooling Cost $22,000 $20,000

Terms 2/10,net 30 1/10, net 30

Distance 125 miles 100 miles

Supplier Quality Rating 2% 3%

(defects)

Supplier Delivery Rating 1% 2%

(late delivery)

Jane also obtained the following freight rates from her carrier:
Truckload (TL >= 40,000 lbs): $0.80 per ton-mile
Less-than-truckload (LTL): $1.20 per ton-mile
Note: per ton-mile = 2,000 lbs per mile

Que.2

Given the following information, use total cost analysis to determine which supplier is more
cost-effective. Late delivery of raw material results in 60% lost sales and 40% back orders of
finished goods.
Order lot size 1,000

Requirements(annual forecast) 12,000 units

Weight per engine 22 pounds

Order processing Cost $125/order

Inventory carrying rate 20 % per year

Cost of working capital 10% per year

Profit margin 15 %

Price of finished goods $4,500

Back-order cost $15 per unit

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Two qualified suppliers have submitted the following quotations:
Order size Supplier 1 Supplier 2

1 to 999 units/order $50. 00/unit $49. 50/unit

1,000 to 2999 units/order $49. 00/unit $48. 50/ unit

3,000 + units/order $48. 00/unit $48. 00/ unit

Tooling Cost $12,000 $20,000

Terms 2/10, net 30 1/10, net 30

Distance 125 miles 100 miles

Supplier Quality 2% 2%
Rating(defects)

Supplier Delivery 1% 2%
Rating(late delivery)

Truckload (TL >= 40,000 lbs): $0.85 per ton-mile

Less-than-truckload (LTL): $1.10 per ton-mile
Note: per ton-mile = 2,000 lbs per mile

Que-3

Using the excepted value decision rule for truck capacity

Tower Distributions provides logistical services to local manufacturers. Tower picks up

products from the manufactures, takes them to its distribution center, and then assembles

shipments to retailers in the region. Tower needs to build a new distribution center;

consequently, it needs to make a decision on how many trucks to use. The monthly amortized

capital cost of ownership is $2,100 per truck. Operating variable cost are $ 1 per mile for

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each truck owned by Tower. If capacity is exceeded in any month, Tower can rent truck at $

2 per mile. Each truck Tower owns can be used 10, 000 miles per month. The requirements

for the trucks, however, are uncertain. Managers have estimated the following probabilities

for several possible demand levels and corresponding fleet sizes.

Requirements (miles/month) 100,000 150,000 200,000 250,000

Fleet size (trucks) 10 15 20 25

Probability 0.2 0.3 0.4 0.1

Notice that the sum of the probabilities must equal to 1.0. If Tower distribution wants to
minimize the excepted cost of operations, how many trucks should it use?

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