Total Cost of Ownership Assignment

ssThis assignment is made available to students at Lesson 4 and is due at the beginning of lesson 9

Background information
Total cost of ownership (TCO) is defined as the present value of all costs associated with a
product, service, or capital equipment that are incurred over its expected life.

Typically these costs can be broken into four categories:

• Purchase price
o Invoice amount paid to supplier
• Acquisition costs
o Costs of bringing product to buyer
• Usage costs
o Conversion and support costs
• End-of-life costs
o Net of amounts received/spent at salvage (such as disposal fees)

Factors to be considered in a TCO Model

1. Building a TCO can be costly and timely

o Use it for evaluating larger purchases. There is no need to spend time conducting
a detailed cost analysis for low-value items that do not produce significant
returns.
2. Obtain senior management buy-in before embarking on a full-fledge TCO
3. Work in a team
o This will reduce the time required to complete
4. Focus on the big costs first
5. Obtain a realistic estimate of the life cycle
o A life cycle that is too long or too short will delay the decision

Building a TCO model requires input from all levels of an organization. There are six steps in
building a model:

1. Map the process and develop TCO categories

2. Determine cost elements for each category
3. Determine how each cost element is to be measured (metric)
4. Gather data and quantify costs
5. Develop a cost timeline
6. Bring costs to present value (if a product will cost $10 three years from now, what does
it cost today?)
 Total Cost of Ownership Assignment

Opportunity Costs is defined as the cost of the next best alternatives. Examples are lost sales,
lost productivity and downtime.

Background information (continued)

Present Value Formula

Present Value (PV) is a formula used in Finance that calculates the present day value of an amount that
is received at a future date. The premise of the equation is that there is "time value of money".

Time value of money is the concept that receiving something today is worth more than
receiving the same item at a future date. The presumption is that it is preferable to receive
$100 today than it is to receive the same amount one year from today, but what if the choice is
between $100 present day or $106 a year from today? A formula is needed to provide a
quantifiable comparison between an amount today and an amount at a future time, in terms of
its present day value.

Example of Present Value Formula

In our example we wish to determine how much money we would need to put into the money
market account to have $3,450,420 one year from today if we are earning 8% interest on our
account, simple interest.

The $3,450,420 we would like one year from present day denotes the C1 portion of the formula,
8% would be r, and the number of periods would simply be 1.

Putting this into the formula, we would have:

PV = $3,450.420/(1+.08) = $3,450,420/(1.08) = $3,194,833

When we solve for PV, we would need $3,194,833 today in order to reach $3,450,420 one year
from now at a rate of 8% simple interest.

Then, solving for period 2, we would have:

PV = $3,450,420/(1+.08)² = 3,450,420/(1.08)² = 3,450,420/(1.1664) = $2,958,179

 Total Cost of Ownership Assignment

Then, solving for period 3, we would have:

PV = $3,408,420/(1+.08)³ = 3,408,420/(1.08)³ = 3,408,420/(1.2597) = $2,705,739

TCO example calculations

In this example, Supply manager Kim Overburgh was considering the purchase of 1,000 new style
programmable Logic Controllers (PLCs) for her organization. The life cycle was three years, and the
organization's cost of capital was 8 percent. She collected the data required for the TCO calculations for
one of the purchase options as shown in the first spreadsheet. Using these elements, the total cost of
ownership is then calculated on the second spreadsheet.

TCO data collection for one purchase option for PLCs

Cost elements Cost measures

Purchase price: (step 1)
Equipment (step 2) Supplier quote: $1,350 per PLC (steps 3&4)
Software license #1 Supplier quote: $275 per PLC
Software license #2 Supplier quote: $110 per PLC
Software license #3 Supplier quote: $60 per PLC
Acquisition Cost:
2 FTE @ $75k/year and $110K/year for 2
Sourcing months
Administration 1 PO @ $120, 12 invoices @ $35 each
Usage Cost:
Installation $900 per PLC (PLC remove, new install, network)
Equipment support $135 per month/PLC, supplier quote
Network support $90 per month/PLC - supplier quote
Warranty $135 per PLC for a 3 year warranty
Opportunity cost-Lost productivity:
Downtime 15hrs/PLC/year @ $50/hr
End of life costs:
Disposal fee $42 per PLC
 Total Cost of Ownership Assignment

TCO calculations for one purchase option for PLCs

Year 1
Cost elements Present (step5) Year 2 Year 3
Purchase price:
Equipment $1,350,000
Software license #1 $275,000
Software license #2 $110,000
Software license #3 $60,000
Acquisition Cost:
Sourcing $30,833
Administration $120 $420 $420 $420
Usage Cost:
Installation $900,000
Equipment support $1,620,000 $1,620,000 $1,620,000
Network support $1,080,000 $1,080,000 $1,080,000
Warranty $135,000
Opportunity cost-Lost productivity:
downtime $750,000 $750,000 $750,000
End of life costs:
Disposal fee -$42,000
TOTAL $2,860,953 $3,450,420 $3,450,420 $3,408,420
Present value @ 8% (step 6) $2,860,953 $3,194,833 $2,958,179 $2,705,739

On the basis of this model, she should explore the possibilities of reducing service costs such as
equipment support and network support— these appear to be the highest value, and contribute most to
costs. This is also typically the most profitable area for the supplier, as services are often not audited.
 Total Cost of Ownership Assignment

The Assignment details

1. Prepare calculations for the TCO for each of the two purchase options for the Newgreen
Corporation, Hotel division. The money market account for Newgreen Corporation is currently
earning 8% simple interest.
2. Determine from your calculations which is the best purchase option based on this data alone.
Explain and provide support for your choice of option. Remember; this is not the only criteria for a
purchase option. In order to do a complete assessment you would need to determine other
factors such as supplier capacity, financial health, ISO certification, etc.
3. Determine from your calculations which are the best possibilities for immediate cost savings. Explain
and provide support and for you choice(s) of options.

The Newgreen Corporation, Hotel division case study

Frederick Gainer, the C.O.O. of the Newgreen Corporation Hotel division, has been getting complaints
from various hotels in his chain regarding the quality of the televisions that are currently in use. The
complaints seem to center around the size, age, reliability and picture quality. He has asked Amy, the
head of Procurement to bring him some details regarding what it might cost to replace and maintain
new “smart” televisions for his top three hotels. Frederick believes that this new technology can be
utilized to return more profits for the Hotel division. He would like to see a yearly cleaning and check-up
on each TV and would like to see them replaced again at the end of the warranty period to alleviate
future problems with these televisions.

Amy found that they will require 1,000 SMART TVs and got written quotes from three suppliers. She has
narrowed the choices to two finalists; Supplier A which is in her own city and Supplier B which is in a
different province. Amy had asked that each supplier quote on installation, removal, maintenance and
disposal of the old televisions. Amy found that delivery costs for Supplier A would cost her $45 per TV
and the out-of-town TVs from Supplier B would cost her $50 each to have them delivered to the hotels
as required.

Amy knew that two of her staff had each used two months to gather all of the quotes and data that she
needed to proceed. One of her staff earned $70,000.oo per year, and the other earned $85,000.00 per
year. For administrative costs she had incurred $95.00 to issue the PO and estimates further
administrative costs to be $360.00 per each year thereafter.

Dave Brenner, on behalf of Supplier A, was very keen on getting her business and quoted a base price of
$675 per television, mounting hardware would be extra at $65 ea. Dave offered an extended warranty
for three years at a cost of $135 ea. Supplier A would be “on call” with equipment support to handle
emergencies for a fee of $25/month/TV and would supply the network for these “smart” TVs at
$80/month/TV. Each TV would take one hour to install at a rate of $125/hour. Amy reviewed the
installation cost for supplier A and determined she would incur lost revenue of $125,000.00 as a result
of the installations of the 1,000 televisions.
 Total Cost of Ownership Assignment

Amy wanted 100 extra remotes to ensure she can quickly replace those that are lost or damaged. Dave
says he can sell her 100 remotes at a cost of $20 each.

Dave says that his company would go to each hotel on a yearly basis to clean the vents etc. on each unit
and test it electronically for any problems. Amy has estimated the cost of this downtime to be $50/hour.
Since this is actually downtime on the units, he maintained that he could limit this downtime to 5
hours/TV/year. Amy has estimated the cost of this downtime to be $250,000.00 per year. Old
televisions would be disposed of for a fee of $42 per TV and would be done locally.

The Newgreen Corporation, Hotel division case study (continued)

Julia Rawlings from Supplier B quoted a base price of $685 per television, mounting hardware would be
extra at only $55 ea and an extended warranty for three years would cost $130 ea. Julia says her
company would be available with equipment support to handle emergencies for a fee of $20/month/TV
and would supply the network for these “smart” TVs at $70/month/TV. Each TV would cost Newgreen
only $100 to have them installed as their crew is very proficient at installations. Amy reviewed the
installation cost for supplier B and determined she would incur lost revenue of $115,000.00 as a result
of the installations of the 1,000 televisions.

Since Amy wanted 100 extra remotes, Julia says she will give her 50 extra remotes at no extra cost, but
will have to charge Amy $20 each for the other 50.

Julia says that her company would not need to go to each hotel on a yearly basis to clean the vents etc.
She says that her company would limit Newgreen’s downtime to only 1 hour/TV/year by simply
“swapping” each unit annually with a pre-cleaned and tested unit. . Amy has estimated the cost of this
downtime to be $50,000.00 per year. Old televisions would be disposed of for a fee of $30 per TV and
would be done at a reputable recycling facility in her neighboring province.