Paging Dr. Lean: What is The Total Cost of Ownership?

In the Paging Dr. Lean series, Patricia E. Moody asks lean experts to answer your lean questions. This forum allows industry leaders to speak to the lean issues or questions you come across each day.

Dear Dr. Lean:

We are trying to be more rigorous about measuring costs, but we have disagreements about the numbers — different opinions on definitions and formulas, plus where to find the right numbers.  We need help on these three questions:

1. How should we measure total cost of ownership? In your experience, how long should it take to develop the framework and what should we include in our logistics data? Which companies do you believe are the best at developing total cost of ownership data/solutions, and are these on spreadsheets or IT apps?

2. We use a lot of cardboard and plastic but we aren't sure we can eliminate all of it from packaging. Tell us how we should be handling shipping materials, and is there a professional group that can help us redesign our approach to take costs out of packaging/shipping materials?  

3. In a Total Cost of Ownership model, what should we do if the ERP system shows different costs from our calculations? What does that tell us?

Sincerely,
Too Many Numbers in Chicago

Dear Too Many Numbers:

As I’m sure you know, there are several approaches to Total Cost of Ownership (TCO), and without knowing your specific business context, I’ll try and answer your questions.

Measuring the Total Cost of Ownership

TCO allows you to answer any number of complex questions including:

• Should I make or buy packaging services?
• Should I pay 12 percent extra to a supplier to get the equipment 23 days earlier?
• What would happen if a natural disaster hit and we lost production for 12 days?

Once you know the question(s) you are trying to answer, you need to identify the cost object(s) you are trying to evaluate to answer your question. You mentioned logistics. Examples of cost objects may include:

• The internal logistics function (a process or activity e.g. in or outsource)
• A particular logistics supplier (a relationship, a contract provision)
• The cost of running a logistics company (a business)
• The logistics to support a major location or project (an asset)
• The logistics or packaging transport to support a product line (a product)

The second part of your TCO framework should consider all of the costs related to the cost object. Costs can be broken into four buckets over a determined period (often the useful life of the equipment or the investment horizon):

• The direct/purchase price (usually the direct price from the supplier for key components, accessories, personnel required)
• Acquisition costs
• Usage costs
• End of Life costs

The final step is to compare the total cost of different options or scenarios and determine which one provides the lowest total cost of ownership after considering the net present value of the immediate and future costs, lead times, exposure, downtime and all the factors discussed above.

Implementing a Total Cost of Ownership Framework

Two common traps I often see companies fall into are:

• Underestimating the need to recognize internal business requirements in their frameworks. For instance, usage and end-of-life costs are almost always underrepresented. Examples include opportunity costs, such as the cost of late delivery, downtime related to breakdowns and corrective maintenance, supply or demand disruptions — especially those based on seasonal factors such as weather — holidays or forgetting to factor in tools, rentals, switching costs, incentives, royalties, remedial or decommissioning at the end of life.
• Failing to gain traction within the organization — you need experts, a cross-functional team that may extend outside the organization to suppliers, subject matter experts or even customers, depending on what questions are being answered. In every aspect of business a cross-functional team is valuable, but with many TCO decisions that affect multiple stakeholders it’s necessary — and this would be my main caution before heading down a path toward a complex TCO.

Determining the scope and significance of the TCO to your organization will be the main driver of how much effort (time) you should invest. I have seen non-strategic supplier selection TCO analysis be as quick as two weeks or very detailed lifecycle analysis for $100 million equipment that may take a team of people three months and have more than 50 variables, simulations, emissions, etc. In that case, it was worth the effort as our client maintained a growing fleet with more than 500 pieces installed across the globe. 

We use Excel, simulation and web based-tools as required. 80 percent of the time I think Excel is sufficient because it is flexible. The question you have to ask is how many people will be touching the tool (configuring/using/updating). Most of the time only a few need the tool itself; the other stakeholders just need a report with the output, scenarios and enough to demonstrate that the process is robust — think PowerPoint or SharePoint.

There are many options for managing the return on capital related to shipping materials, including type, design and processes for packaging, the suppliers, the use and types of products being shipped, temperature, modes of transport, etc. Unfortunately, I don’t have any generic tips for this question; it would have to be context-specific.

Many major consulting firms and the major logistics providers offer services related to managing logistics, including concepts related to total cost. Again, without knowing your business context, I don’t think I could recommend one over the other, but contact me below and I’ll happily point you in the right direction.

The standard costing modules built into an ERP are typically designed for a specific purpose typically related to the cost of goods/services measure from an accounting perspective and are required to know how much financial profit a product line/division/company has made. However, ERPs are not usually purpose-built to answer the specific complex questions we discussed above, so an ERP costing system will not typically include hidden or opportunity costs nor would it include an estimate of costs that occur in the future as a TCO would. I’m not an ERP expert, but I know they are extremely customizable and can incorporate/integrate just about any model or software you require but the cost tends to rise exponentially based on the added complexity/interactions.

Sincerely,
Jimmy Anklesaria
President and CEO
Anklesaria Group, Inc.
 

Jimmy Anklesaria is president and founder of the Anklesaria Group, a management consulting, training and seminar practice based in San Diego that has helped thousands of companies get a handle on their costs. He is the author of The Aim and Drive Process and Zero Base Pricing.

Dear Too Many Numbers:

How should we measure total cost of ownership? In your experience, how long should it take to develop the framework, and what should we include in our logistics data? Which companies do you believe are best at developing total cost of ownership data/solutions, and are these on spreadsheets or IT applications?

Data gathering is the backbone of TCO and is the most time-consuming part of the puzzle. Also, you will depend on different people to gather soft dollars, which makes it even more time-consuming.

Most costs are made up of two factors — hard dollars that appear on the ERP and soft dollars that don’t. Generally speaking, soft dollars are a smaller portion but difficult to capture.

TCO = Purchased price + acquisition cost + plant cost or usage cost + disposal cost
Purchase price is easy — get it from the ERP.

Acquisition cost is the cost you incur when you buy goods or services. Most of the acquisition cost is in the soft dollars, but may have some hard dollars as well. Soft dollars may include training, inspection of work and rework, insurance, etc. Talk to subject-matter experts to understand soft dollars. You will probably have to convert your conversations into mathematical equations. Such as, if two people of your own organization are involved for one-third of their time, then that is two-thirds of one person working full-time. Then if their average cost (not their average salary) to the company is $150,000, that makes it $100,000 per year.

Usage cost depends on the product you are dealing with. There is not much of usage cost if it is a mechanical valve, but if it is something that runs on energy, such as electricity or fuel, you need to calculate usage cost. Also usage cost is incurred throughout the life of the product, which may be years.

Disposal cost is incurred at the end of the life of the product. That means you need Finance 101 to convert usage costs and disposal costs into their present value. If present value calculations are too much work to do, ask your friends in the finance department for help; they should be able to do that easily.

Add all costs together and you have your TCO.

Time required to have a TCO depends on the spend you are looking at. Generally speaking, for up to $100 million, it usually takes one week to three weeks to gather data (including soft dollars), and approximately one week to analyze it (understanding the data and only selecting what you need). Afterward, it should not take you more than a couple of days to have your TCO. Overall, it takes three weeks to five weeks to have a TCO.

Generally speaking, a TCO model is not very complicated; after all, you are adding a bunch of numbers, but it is cumbersome. Whether you use a spreadsheet or an IT application depends on what you are comfortable with. I prefer a spreadsheet because I know what is happening inside and how I am getting what I am getting — it makes it easier for me to understand and explain it to others. I am sure there are applications that can do just that.

In a Total Cost of Ownership model, what should we do if the ERP system shows different costs from our calculations? What does that tell us?

You should be worried if they match, because they never do. One reason is that your TCO captures soft dollars while the ERP only captures what you pay to your suppliers. Even the hard dollars never match. I stop chasing dollars when I have to spend $100 to figure out where $50 dollars went (Do you really want to capture the electricity cost of the air conditioning, light bulbs, the projector, etc. your supplier used at your facility?). Use ERP as a guideline to have an idea of the hard dollars.

Best Regards,
Syed Hasan
Strategic Sourcing Specialist

Syed Hasan has worked in the automotive and petrochemical industries, and has 15 years of work experience and two master degrees — an MSME and an MBA. He has strong educational and practical background in supply chain management and engineering. He has led the development and execution of multiple national and global projects. His areas of specialization include market intelligence, supply chain management, strategic sourcing, financial analysis, engineering, design development, risk evaluation mitigation, project management, failure root cause analysis, TCO analysis, cost modeling, strategy development and implementation.

Dear Too Many Numbers:

Thanks for writing to Dr. Lean looking for “Cost” guidance. That is what we intend to provide you … and all the other readers with — guidance. Our responses will be derived from our years of experience and should be really great but, they carry with them zero warranty. Sorry. Can’t give you your money back, we didn’t ask for it. 

As to our responses and opinions? Use it or ignore it. Embrace it or eschew it. Love it or hate it. That choice is entirely up to you. We think what we offer has value born from years of sometimes painful, sometimes exhilarating experience that helps feed our keen insight. But then again, we have been known to be wrong from time to time. At least that is what Mrs. Lean says. You are ultimately in the driver’s seat and are the ultimate arbitrator here.

In our humble opinion you have taken a great first step — you have looked outside yourself and your immediate surroundings to see if you can’t find “better.” Good for you! You may not find anything, but then again, you will never know if you don’t seek. Here’s to the seekers! Let’s all continue that striving for better.

1. How should we measure total cost of ownership? In your experience, how long should it take to develop the framework and what should we include in our logistics data? Which companies do you believe are best at developing total cost of ownership data/solutions, and are these on spreadsheets or IT applications?

Dr. Lean has a mantra that’s made him famous — “Cost is a result!”  Don’t forget this. Chant this six times in a row before you start each workday. You will be a better person if you do.

To the answer about the total cost of ownership, you first need to get a good grasp of your item or part’s basics. What are the requirements and specifications — “reqs and specs” for the item? What volumes are needed? What materials are called for? What processes are needed to create the item? Will the item be manually made or from an automated process? Will it come out of a single cavity mold, for example, or can it be produced in multiples? Are the tolerances associated with the item forgiving and easy to hold or do they demand precision manufacturing and extra care? Are secondary plating, painting, heat treating, grinding or other processes called for? Is this something available anywhere, or is it unique with constrained sourcing possibilities? Is the item technologically stable (a common fastener) or is it subject to technological obsolescence (an electronic device)? 

Will you make or buy the item? Does your company currently have the capability to produce the item? Do they have the capacity to produce the item? If yes, OK. If no, is this something your company wants to get into? Does it fit with the company’s core business strategies? What supplier choices and sourcing plans do you have for the part in question? If buying, will you do it locally or overseas? Will there be foreign currency exposure involved? What kind of lead times and market responsiveness does your end customer seek? Can you carry out your supply plans — or even surprise or delight them? What kind of packaging and shipping will be required to protect the integrity of the item? This includes traversing the globe up to, and including, the material handling and movement within the confines of your facility. Will you need to tool up for this part? Who will own the tool? How will you handle the replacement of the tool, die, jig or fixtures associated with the manufacturing and quality assurance of the item? How will you handle the recognition of the annual depreciation in your costing? Will your company bear any post usage warranty exposure? And so on.

In the world of cost, the devil really is in the details. It is through detailed answers to these detailed questions about the item that help you come to recognize the costs for the item. It is more than just the quoted piece cost. In getting to the total cost of ownership, you first need a heightened awareness of all these inputs and how they drive your costs. 

You may have a $50 “$10” part. Your decisions on reqs and specs, make/buy, sourcing and other key variables may drop you off in that $50 neighborhood, while other others may end up in the $30 neighborhood due to their decisions/executions of their processes, while others still may approach the $10. This is where competitive advantages are made and lost.

You ask how long it should take to develop this framework and should logistics be included. Let me respond in reverse — yes, by all means include logistics. To ignore is folly. Dr. Lean remembers when logistics was approximately 2 percent of a parts total cost, so including or missing had little impact. But then, gas used to cost just 27 cents a gallon. (Yes, it really was! Go ask your grandparents.) Today, logistics costs can approach 8-10 percent of a part’s costs. You have to capture it. As to the framework, our experience has been this is a “30/70” item. What? 30 percent to set it up, then more than twice the time — 70 percent — chasing down the inputs and/or setting up the reliable sources and processes by which your organization can reliably get the info to populate the framework. This is like four months into the task being reliably up and running.

Dr. Lean is going to try to avoid mentioning specific companies or products so as to not appear to be shilling for them. We are a neutral party and wish to retain the appearance/reputation as being so. That said, there are some fairly sophisticated companies we know that really do a nice job of capturing true total ownership costs. And in this instance, I am a strong supporter of going directly to the IT solution, skipping over the spreadsheet route because this issue is not new; many have wrestled with and some really great products were developed out of this universal need. We see no need to become yet another designer of “the wheel.” It has been done. We were too late to this party. Save yourself from being a wheel designer and get on with your valued added tasks of cost management. And, as you explore some of the IT tools available for this purpose, we’d urge you to ask the purveyors who is using their tool. You’ll quickly come to the realization who some of those sophisticated firms are. I will suggest that one of your stops ought to absolutely include discussions with aPriori. Those guys and their product are good. (Send the fee boys to the usual PO box!)

2. We see a lot of cardboard and plastic but we aren't sure we can eliminate all of it from packaging. Tell us how we should be handling shipping materials, and is there some professional group that can help us redesign our approach to take costs out of packaging/shipping materials?

The use of returnable containers in logistics is great, but, it depends on volumes to justify the investment. We have never personally seen nor experienced complete elimination of dunnage. I have started to hear of some firms bragging that they have gone “green” and don’t have any, which leads me to wonder — at what cost? Bragging rights are nice, but …

In all the firms Dr. Lean has worked in, we have always had a dedicated group of logistics and packaging specialists. We hired ’em. Why? Well, this area is a specialty within materials management and sourcing. I like my podiatrist, and even though he is a medical doctor I would not have him do my heart bypass! The area of packaging science is best left to those folks. My current specialists in this area tell me what to do. 

3.  In a Total Cost of Ownership model, what should we do if the ERP system shows different costs from our calculations? What does that tell us?

When in doubt, trust your eyes. Dr. Lean is a GEMBA guy like there is no tomorrow. Go to the spot and grasp the current reality. If my Navi in my Acura (PO box fellas!) says a road is supposed to be there but I see none, I do not blindly turn off into the ditch just because the crazy system said to. You should not either. My years of auto industry experience included training in what we called “The 3 A’s” — actual spot, actual part, actual reality. You get up outta your chair, out of your office and go to the actual spot. You use your God-given senses and look, listen, feel, smell and taste (Yes, taste  Ever been in a machining operation heavy with the oils and results from chips generation? Or a casting operation? You can practically taste the operation. Would you want to work eight hours in at a process, in an environment like that? Good indicator of need for changes too). You see the part, you pick it up, you look at it, you see how it is being used, you look for problems or issues … you grasp the reality.

Another consideration needs to be, “How far off are your calcs from the model’s?” Some percent of variance is OK. For example, 10-15 percent maximum would be our personal tolerance. Beyond that, investigation is required. It can be input timing differences, assumptions or … gulp … mistakes. Yes, they do happen. Embrace them and learn from them. That’s how real growth occurs.

What does the existence of a gap tell you? It tells you “Normal!” I would be more bothered if I were seeing near perfect alignment; it would cause me to start to question what am I missing. Our experience has been that whenever we got into discussions with suppliers, for example, where we had calculated a value and they had calculated a value for the same thing, we were seldom in agreement. Good. Let the discussions begin. From that closer, but rarely perfect, alignment, and agreement would be reached — at least enough to engage in commercial relationships.

Hope this has been of some help!

Very truly yours,
Peter G. Schmitz
Manager, Motorcycle Cost Management, Product Development Center
Harley-Davidson Motor Company

Peter G. Schmitz has more than 30 years of experience working in purchasing, cost management, product development and industrial engineering processes. Prior to joining Harley-Davidson in 2001, he worked at Actuant Corp., Honda of America Mfg., Inc., Black & Decker and John Deere. He has an MBA from the University of Iowa and lifetime CPM from ISM. He is a graduate of Honda’s intensive one-year lean training program and has been a speaker at CAM-I’s target costing seminars. He has taught a seminar on lean purchasing at the University of Wisconsin-Madison.