Total cost of ownership approach; an enabler for better procurement performance

Total cost of ownership in procurement

This article is part of SCM Knowledge educational resource.

What is procurement

The Chartered of Institute of Procurement and Supply (CIPS) defines procurement as the business management function that ensures identification, sourcing, access and management of the external resources that an organization needs or may need to fulfill its strategic objectives.

In simple terms, procurement deals with the sourcing of goods and services at a strategic level supporting the organization’s objectives.

The procurement process starts with a need or demand by which the company responds to it by supplying the product or service. Fulfilling the demand effectively requires sourcing of materials or services at the minimum cost without sacrificing value to internal and external stakeholders. Keeping the balance between cost and value takes a strategic approach throughout procurement activities. That is where the total cost of ownership (TCO) comes into play.

Before the company sells a product to customers, raw materials need to be purchased from the supplier to make a final product. There are two types of purchases;

Direct purchases – things you buy that go directly to the creation of the final product. If you manufacture computer, chips and electronics are examples of direct purchases.

Indirect purchases – things you buy that do not become part of the final product. Janitorial materials to keep the factory clean are examples of indirect purchases.

The procurement is a major influencer in determining how your supply chain will perform. Buying in bulk will save you money but increases inventory costs. Entering into long-term contracts will get you a discounted price but reduces the flexibility of your supply chain. There is a need to look beyond the price. A traditional purchasing approach – just focusing on material cost reduction – is no longer a sustainable procurement strategy because it causes inefficiencies to other aspects of the supply chain.

Total cost of ownership

Successful companies operate by reducing the total cost of ownership. The TCO encompasses cost metrics that help companies measure the total cost of ownership. Cost metrics include costs associated with purchasing, logistics, manufacturing, quality, risks, and other aspect impacting the supply chain performance. Simply put, TCO is the cost to buy, operate, maintain, and recycle.

Total cost of ownership in procurement
Total cost of ownership (TCO) model.

We see in the above table that Material A has the lowest TCO than Material B even though the purchase price is 100% higher than Material B. We can also infer that a supplier’s price is just a fraction of the TCO. Material A is cost-effective in the long run over Material B. Under the traditional approach where the buyer’s decision is driven by the price, Material B would have been the first choice.

In analyzing the TCO, a strategic sourcing approach must be used. In strategic sourcing, buyers will determine the impact of the purchase price to the TCO by quantifying its cost contribution across supply chain metrics. The trade-off analysis is extremely useful to determine a favorable TCO. The goal of strategic sourcing is to reduce the entire supply chain costs as the company’s resources are primarily tied up on inventory. How inventory is managed across the pipeline determines the financial and operational performance of the organization.

Strategic sourcing decisions include:

  • Reduce total cost of ownership
  • Optimize inventory
  • Supplier quality and relationship
  • Information sharing

Procurement Process

Buying materials takes critical steps to successfully operate the procurement function. Gone are the days where the buyer simply goes to the supplier to purchase and wait for delivery after payment. Given the complexity of customer requirements and globalization, the purchasing activities today need to be strategic and data-driven.

Procurement process.

A better understanding of the total cost of ownership not only saves costs but also improve sourcing visibility and support product sustainability.

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About the author

Marvin Bunyag, CPIM

Founder, ExploreSCM

Marvin is an APICS – CPIM professional bringing 6+ years of international experience in supply chain logistics, technology, and manufacturing operations in the USA and the Philippines. Marvin served in several supply chain roles for companies including Kohler, Hood Packaging Corporation, and Unifrutti Philippines. He received his MS in Operations and Supply Management from the University of Wisconsin in USA and a BS in Commerce at the University of the Immaculate Conception in the Philippines.

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