Posted Courtesy of Marty Shcmidt.
Acquiring certain assets like water or wastewater treatment plants brings significant purchase costs but these can be overshadowed by other large costs that appear during a long service life. TCO analysis attempts to uncover both the obvious costs and the “hidden” costs of ownership.
Waterform Technologies places a emphasis on TCO as it is in clients best interest rather than just taking a capital price approach and therefore leaving real value aside. This article uses anecdotes from the IT industry however it can be applied anywhere in business purchasing.
Total Cost of Ownership(TCO) is an analysis meant to uncover all the lifetime costs that follow from owning certain kinds of assets. As a result, TCO is sometimes called life cycle cost analysis.
Asset ownership brings purchase costs, of course, but ownership also brings costs due to installing, deploying, using, upgrading, and maintaining the same assets. These after-purchase costs can be substantial. Consequently, for many kinds of assets, TCO analysis finds a very large difference between purchase price and total life cycle costs. And, the difference can be especially large when ownership covers a long time period. As a result, TCO analysis sends a very strong message to corporate buyers, capital review groups, and asset managers:
Consider TCO instead of purchase price when making purchase decisions!
Those who purchase or manage computing systems have had a keen interest in TCO since the late 1980s. At that time, IT industry analysts began publishing studies showing very large difference between IT systems prices and systems costs. And, not surprisingly, these soon got the attention of IT vendor sales teams and marketers.
Competitors of IBM, for instance, used their own TCO results to argue that IBM systems were overly expensive to own and operate. This kind of argument is possible because the five year total cost of ownership for major hardware and software systems—from any vendor—can be five to ten times the hardware and software purchase price.
Today, TCO analysis supports purchase decisions for a wide range of assets. These include especially assets with large maintenance and operating costs across ownership life. Total cost of ownership is therefore center stage when leaders face purchase decisions for large IT systems, vehicles, buildings, laboratory equipment, medical equipment, factory machines, and private aircraft, for instance.
As a result, TCO for these kinds of assets is a central focus in the following:
Sections below further explains and illustrates Total cost of ownership in context with related business concepts from the fields of asset management, budgeting, and cost accounting.
Cost of ownership analysis attempts to uncover both the obvious costs and the so-called “hidden” costs of ownership across the full ownership life cycle of the acquisition. Usually, however, there is room for judgment and different opinions regarding the appropriate lifespan to analyze.
In defining ownership life, owners may consider several “lives” that are in view:
All of the above lives may be different and all may contribute to the owner’s judgment as to the length of the ownership life. In addition, however, the lifespan for TCO may also depend on the owner’s purpose for the analysis.
Firms sometimes set ownership life as the complete time that ownership has financial impact. This is the rule in two cases. Firstly, when TCO analysis supports budgeting and planning activities. And, secondly, when TCO supports strategic decision making. In these cases:
Alternatively, TCO analysis may cover an arbitrary number of years, for example, 3 years, 5 years, or 10 years. This approach is usual when:
TCO analysis begins when the owner identifies or defines two things:
TCO analysis continues when the analyst identifies important cost categories likely to have cost impacts due to ownership. To be sure the study includes all important costs, TCO analysts consider two kinds of cost categories. These are, firstly, obvious costs,and secondly, hidden costs.
Obvious costs in TCO are the costs familiar to everyone during planning and vendor selection, such as:
The so-called hidden costs are the less obvious costs due to ownership—costs that are easy to overlook or omit from acquisition decisions and planning. Costs of this kind can be very large and real, nevertheless. The discovery that hidden costs for certain assets can be quite large is in fact the reason TCO analysis exists.
All hidden costs that turn up in TCO analysis belong in the TCO summary if both conditions apply:
The list of hidden cost categories above could of course extend further for many kinds of acquisitions.
TCO analysis uncovers obvious and hidden costs when the analyst anticipates cost impacts in all the categories above—and sometimes more. The analyst, in other words, creates an inventory of cost categories. Consequently, the analyst begins finding cost categories by interviewing those familiar with the asset’s usage.
In addition, suggestions for finding relevant cost categories may come from other sources, including:
Simply naming the cost of ownership subject does not fix boundaries for the analysis. The analyst must still decide and communicate which costs belong in the analysis and why. Consider, for example, the case when TCO analysis applies to a potential IT system acquisition.
In each of these situations, the TCO analysis serves a different purpose, and each calls for its own cost model (see next section). When using TCO results, remember that analyst judgment plays a role choosing which cost categories belong in the analysis and which do not. This is because analysts are free to choose categories that best serve the purpose of decision makers and planners.
In conclusion, when a TCO analysis compares different scenarios or action plans, be sure that all scenarios use the same TCO cost model.
The TCO analysis continues by designing a comprehensive cost model that covers the TCO subject through ownership life while supporting the decision maker needs.
Making the step from a complete inventory of obvious and hidden cost categories, to a comprehensive cost model, requires the analyst to look for specifics in these areas:
Why does the analyst invest time and effort in going beyond the list of cost categories to organize them as cost model? There are two reasons for the model:
For a more on cost modeling (resource-based modeling and activity-based modeling) please see Business Case Essentials .
The cost model in Exhibit 1 below is simply a two-dimensional matrix whose cells represent categories that could have cost impacts due to ownership. Here, for example is a TCO model for an IT system acquisition.
|COST MODEL||Acquisition Costs||Operating Costs||Change Costs|
|Software||Obvious costs||Obvious costs||Hidden costs|
|Hardware||Obvious costs||Obvious costs||Hidden costs|
|Personnel||Hidden costs||Hidden costs||Hidden costs|
|NW & Comm||Hidden costs||Hidden costs||Hidden costs|
|Facilities||Hidden costs||Hidden costs||Hidden costs|
Exhibit 1. TCO cost model for an IT system acquisition. Rows are resource categories and columns are IT life cycle stages. The contents of each cell are individual resource items. Exhibit 2, below, shows typical cost items for two cells in the Exhibit 1 model.
Note that here, the vertical axis represents IT resource categories while the horizontal axis represents IT life cycle stages. The model design succeeds when it achieves two objectives:
The two axes, that is, should convey self-evident completeness. If they do, there should be no unpleasant cost surprises later, during implementation. And, the analyst should never have to answer questions such as: Why didn’t you include this? Or that?
Examples below show that the choice of cost categories for each axis gives the model power for analysis and communication.
The TCO analyst continues by adding the names of resources to each cell. Resource items that go together in a cell have two characteristics:
For a planning an IT System acquisition, two of the model’s cells might hold the resource names in Exhibit 2:
Exhibit 2. Resource items in two cost model categories.
Other cells in the same model have similar resource lists. As a result, the full model helps assure TCO analysts and owners that every important cost item due to ownership is in view. And, it helps assure everyone that the analysis excludes costs not due to ownership. As the following sections show, it is also a powerful tool for analyzing life cycle costs.
Finally, the cost model helps assure all involved that scenario comparisons are fair and objective. One model can do this if the single model design covers all relevant costs in all scenarios. Of course some items may have 0 values in one scenario and non zero values in others. As a result, using one model with the same cost categories for all scenarios shows everyone that TCO comparisons between scenarios are fair.
The cost model (above) provides the TCO analyst with a list of cost items—the contents of all the model cells. The analyst must then estimate cost figures for each item, for each scenario, looking forward to each year of the analysis
Exhibit 3 below, for example, shows analyst estimates for just one cost item: Server System Purchase.
Exhibit 3. When the TCO analysis has 2 scenarios and a 3-year life in view, the analyst makes 6 cost estimates for each item. Here, the cost item Server system purchase appears in two TCO scenarios: Business as Usual and Proposal. Each year’s incremental cash flow estimate calculates therefore as:
Incremental Cash Flow = Proposal Estimate – Business as Usual Estimate.
Methods for making these estimates are beyond the scope of this article, but very briefly, the analyst will use several kinds of information to make these estimates. For the IT example, the analyst forecasts cost drivers for each item, under each scenario. These may include, for example, costs due to numbers of users, transaction volumes, and storage space needs. The analyst will also consider information from the vendor, experience with similar systems in other settings, and industry standards and guidelines.
With cost categories and cost items from the cost model, the analyst can build the primary analytic tools in the TCO study: cash flow statements for each scenario.
Exhibit 4 below shows cash flow statement structure. Note especially that many line items from the model are omitted here, so as to show the structure clearly.
Exhibit 4. A TCO analysis with two action scenarios (Proposal and Business as Usual) has three cash flow statements. And, all three have the same cost items and structure, as in the example above. The analyst therefore produces two full value statements (such as the statement above) and one incrementalstatement. In the incremental statement, each figure calculates as the Proposal scenario estimate less the Business as Usual estimate.
The cash flow statements are in one sense children of the cost model. This is because cash flow statements take line items from the model and thus retain some of the model’s structure. In brief, the cash flow statements have the parent model’s vertical axis categories. However, in the horizontal dimension, the statements present a time line covering the TCO analysis period instead of life cycle stages. The task for the TCO analyst is to estimate cost figures for each year, due to each item, for all scenarios.
The Business as Usual scenario is an important part of any TCO analysis. It recognizes that owners will still spend money on many of the same IT cost items, even without the new system. As a result, the Business as Usual scenario therefore serves as a baselinefor comparison. In fact the baseline provides the only way to measure cost savings and avoided costs. For this reason, the TCO analyst uses scenarios 1 and 2 to construct a third scenario:
This scenario simply shows the cost differences between corresponding line items on scenarios (1) and (2). Note especially, again. that all three cash flow scenarios have the same structure (as above) because they all derive from the same cost model.
Finally, the TCO Analyst will use the “bottom lines” of the cash flow statements to compare scenarios using standard financial metrics, such as
And, if the Proposal scenario shows cost savings, or avoided costs, relative to Business as usual, the analyst can apply investment metrics to the incremental cash flow values, such as:
For more on these metric, see the articles linked to metrics names above.
When Proposal Scenario costs in some areas are lower than the corresponding Business as Usual Scenario costs, the Incremental cash flow statement therefore shows cost savings in these areas. As a result, cost savings can be treated as cash inflows.
When cost savings are present, the analyst can approach the incremental cash flow statement with investment-oriented metrics such as return on investment, internal rate of return, and payback period. All of these metrics require cash inflows as well as outflows. And, these appear only on the incremental statement.
In that case, a TCO analysis summary might include an array of financial metrics that looks like Exhibit 5.
|3-Year Figures in $1,000||Proposed
|Total Cost of Ownership||$14,256||$17,258||$(3,002)|
|Capital Expenses (CAPEX)||$1,219||$707||$511|
|Operating Expenses (OPEX)||$13,037||$16,550||$(3,513)|
|Net Cash Flow||—||—||$2,981|
|Net Present Value @8% (NPV)||—||—||$2,365|
|Internal Rate of Return (IRR)||—||—||121%|
|Return on Investment (ROI)||—||—||24.9%|
|Payback Period||—||—||7 months|
Exhibit 5. Comparing two TCO scenarios with financial metrics. Notice especially that the “invesment metrics” apply only to the Incremental cash flow summary.
Negative values (in parentheses) indicate cost savings under the Proposal scenario relative to Business as Usual. Those who want to understand fully the basis for these metrics from must review all three cash flow statements.
The TCO results above seem to show a clear advantage for choosing the Proposal Scenario over Business as Usual. However, the analyst’s work continues. After reviewing the above, for instance, questions such as the following will arise.
” If we implement the Proposal Scenario Acquisition …
The analyst addresses such questions by returning to the cost model itself (next section).
Cost model categories for the cost model rows and columns were chosen to represent cost areas that need careful planning and control over a three year period. Once the scenario cash flow estimates exist (previous section), the analyst can use the model to show cost dynamics not easily seen in the cash flow statements.
Here, the cost model cells in Exhibits 6A, 6B, and 6C hold 3-year totals for items in each cell. The figures that go into each sum, of course, come from the cash flow statements.
Proposal System Acquisition Scenario
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs||Total||% of
|NW & Comm||255||1,082||892||2,229||15.6%|
|% of TCO||12.8%||50.3%||36.9%||—||100.0%|
Exhibit 6A. Three-year cost estimates for the Proposal scenario.
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs||Total||% of
|NW & Comm||146||543||459||1,149||6.7%|
|% of TCO||5.9%||55.7%||38.4%||—||100.0%|
Exhibit 6B. Three-year cost estimates for the Business as Usual scenario.
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs|
Exhibit 6C. Incremental totals for cost estimates. Each cell represents the value from a cell in Exhibit 6A, less the corresponding cell vale in Exhibit 6B. Negative incremental values in parentheses indicate cost savings under the proposal scenario.
The analysis in these three tables provides a wealth of useful information that management can put to good use, regardless of which scenario they choose to implement. The next section discusses just a few of the messages brought out by the cost model analysis.
TCO can bring out so-called “hidden” costs of ownership. In this example, owners chose to include all the important costs from system acquisition, including labor costs for people who use or support the systems.
When deciding whether or not to acquire a new system, it is easy to focus excessively on hardware and software costs. Leaders should focus instead, however, on the Personnel costs that come with the system. These “People costs” are 68.8% of the very large TCO. As a result, how these people are trained, employed, and managed will ultimately play a greater role in determining actual cost of ownership than other factors, such as the choice of HW or SW vendor.
TCO can help spotlight potential cost problems before they become real problems.
In the IT world, for instance, change costs can often exceed forecast and budget. These typically include costs due to upgrading, adding capacity, reconfiguring, adding users, migrating to different platforms, and so on.
All of the change cost items in this model could appear instead under either of two cost column headings, Acquisition or Operating costs. Here, however, the analysts chose to focus on change costs by giving them a Change cost column of their own. As a result, it is easier to measure, plan, and control costs specifically due to change. Note especially in this example, change costs represent between 35 and 40% of total cost of ownership in both scenarios.
An Incremental Cash Flow Statement Finds Cost Savings and Avoided Costs.
In this example, Proposal Scenario costs are larger than Business as Usual Costs in almost all cells of the cost model. Business as Usual costs are greater in only two cells: Personnel Operational Costs and Personnel Change Costs. Here, however, the Proposal Cost Savings show up as very large negative numbers in the incremental cost model summary. Those two cost savings are more than enough to give the Proposal Scenario a large TCO advantage.