Total Cost of Ownership:

Application in Supply Chain management

ITC
  

Competetive Advantange ?
 Competetive  Advantange:
Output of supply Chain Analysis

 Quality

 Availability
 Customer service & responsiveness
 Low cost

Supply Chain Management:

A Competetive Bying Tool
The Process of Selecting Supplier’s Offers ?
The Process of Selecting Offers
Set supply targets
Position the item Analyse supply markets
& priorities
Determine the item-specific supply strategy Identify &
(& the desired supplier relationship) appraise suppliers
1
Determine the criteria for evaluating offers
2 Decide on which suppliers to invite
3
Prepare the invitation to suppliers
4
Communicate the invitation to suppliers
5
Receive & evaluate the offers
6
Negotiate the offer (if applicable)
7
Accept an offer/award the contract
8
Advise & de-brief unsuccessful suppliers
 Possibilities for evaluating
suppliers’ offers

Lowest price
Lowest total cost
of ownership

Weighted scoring

ITC
 1. Lowest price
 Suppliers’ offers are tested for compliance
against minimum requirements, e.g.:
Does the offer meet your specifications?
Can the supplier deliver on schedule?
 If they meet or exceed these criteria, they are evaluated on the
basis of their offered price, e.g.:
Evaluating offers for supply of office PCs
Meets minimum:
Registered
Supplier Delivery Price Selected:
supplier? Specification
schedule
A Yes Yes No
B Yes Yes Yes $ 42,300 No
C Yes Yes Yes $ 47,500 No
D No
E Yes No
F Yes Yes Yes $ 38,900 Yes
G Yes No
ITC
 2. Weighted scoring models
Suppliers are scored against criteria that have been
“weighted” to reflect their relative importance
The supplier with the highest overall score is
awarded the contract / order
Cost is treated in the same way as all other criteria

The supplier must be selected on the overall

assessment of many relevant criteria, of which cost
will be just one

ITC
 3. Lowest total cost of ownership
(TCO)

Suppliers are, again, tested for compliance

against certain minimum requirements

If they meet or exceed these criteria, they

are evaluated on the basis of the total cost
of ownership resulting from their offer

ITC
 Capital Costs Supplier A Supplier B
(USA) (China)
Cost of system 130,000 80,000
Transportation 10,000 15,000
Installation cost 5,000 0
Insurance 5,000 5,000
  CE=150,000 CE=100,000
5 years 5 years
OPS Expense OPS EXPENSE
50000 per year 100000 per year
Cost = 375000 Cost = 600000
Revenue = 700000 Revenue = 700000
Profit = 325000 Profit = 100000
Working capital 10,000 10,000
 Features of the TCO approach...

It attempts to quantify all costs - and

revenues - associated with a particular
purchase

Some costs may be “negative”, i.e.

there is a cash inflow, such as
when a piece of equipment can be
sold on the second-hand market
or for scrap at the end of its life

ITC
 TCO components: 1-Esti
2- esti
exp
Purchase or capital cost 3-estim
4- find
Operating costs 5- find
Electricity costs 6- dec

Repair costs
Cost of disposal
Material costs
Other costs, e.g. insurance

ITC
Other considerations, e.g.: output levels
 Quantifying each cost
You need to quantify each of the
component costs and tabulate them over
the lifetime of the equipment
In most cases, it is sufficient to look at
total annual costs
You may exclude certain costs if:
 The cost is very small compared with other costs
 The cost can be expected to be similar
for all offers

ITC
 Calculating the TCO using the Net
Present Value (NPV) approach
NPV takes the time-value of
money into account in calculating
12
the total cost of ownership 9
6
3 =
It re-states all costs in terms of
the equivalent cost today, i.e. the
“present-day equivalent cost”

Future costs are thus “discounted” back to the present!

ITC
 NPV - the discount rate
The discount rate to use will depend on the cost (e.g. interest rate)
of the source of funding for the purchase. The funding can include…

 Bank account in credit

 Bank overdraft
 Bank loan
 Issue of shares
 Issue of bonds
X
5
2
When various sources are used, the discount rate is the weighted
average cost

ITC
After following the evaluation procedure, supplier A and B
have been shortlisted for procurement of complete Manufacturin
system of the factory. There is not salvage value.
company will obtain funds at 15%. Costs will change with increase
in Revenue. Both the supplier have quoted the cost of system as
per following:

Capital Costs Supplier A Supplier B

Cost of system 130,000 80,000
Transportation 10,000 15,000
Installation cost 5,000 0
Insurance 5,000 5,000
  150,000 100,000
Working capital 10,000 10,000
 Supplier A
Year 0 1 2 3
Operating Costs   Pv= FV/(1+i) n     
Raw material usage   70,000 90,000 110,000
Electricity   10,000 20,000 40,000
POL   10,000 15,000 20,000
Salary expense   30,000 45,000 60,000
Rent expense   20,000 20,000 20,000
Capital cost 150,000 - - -
Working capital cost 10,000 - - -
Net cash flows 160,000 140,000 180,000 250,000
 
160,000 140,000/(1.15)1 180,000/(1.15)2 250,000/(1
 
NPV @15% 160,000 121,739 136,105 164,379

700000 - 582,223 = 118000 NPV

 Supplier B
Year 0 1 2 3
Operating Costs        
Raw material usage   90,000 110,000 170,000
Electricity   20,000 40,000 50,000
POL   15,000 20,000 30,000
Salary expense   45,000 60,000 60,000
Rent expense   20,000 20,000 20,000
Capital cost 100,000 - - -
Working capital cost 10,000 - - -
 110,00
190,000 250,000 330,000
Net cash flows 0
 
110,000 190,000/(1.15)1 250,000/(1.15)2 330,000/(1.15)3
 
NPV @15%
110,000 165,217 189,035 216,980
 
700000- 681,232= 19000
 Quantifying each cost: issues to
consider
 Currency
 Treatment of costs already incurred
 Treatment of cash inflows (revenue)
 Treatment of inflation

ITC
 When to use TCO
Appropriate to use when:
 There are relatively significant ongoing costs after the
purchase has been made.

 There are trade-offs between the purchase price and other

costs such as operating cost.

 The value for money is important. The true value can only
be determined with an understanding of all costs involved.

TCO is usually associated with major capital purchases, but is

generally relevant for a significant proportion of all purchases

ITC
Questions ?
Thank You