In any business, it’s important to understand the total cost of ownership and its components. A simple total cost of ownership definition is: a financial estimate that takes into account all direct and indirect costs of an asset or system, be it an entire company, a supply chain, or a single item.
Total cost of ownership (TOC) has many applications. It can be used to help make purchasing decisions or to determine your approach to building a warehouse for your company. It can be used to figure out the best place to manufacture a product or to evaluate your software.
Many consider TOC to be the best approach to assessing true costs of assets or systems. According to Ranjan Sinha, an expert in supply chain logistics, “Total cost of ownership (TOC) is the single most important principle in all of supply chain management.”
Direct and Indirect Costs
Direct costs are usually obvious. For instance, let’s say you’re in the market for a new excavator for your construction business. The direct costs include the out-of-pocket expenses you will incur to acquire your machine, like the price and the cost to have it delivered.
The tricky bit is determining indirect costs. For this, you’ll need to get creative and think long-term, because the total cost of ownership definition includes all expenses over the life of whatever you’re assessing.
In the case of your excavator, this will include costs such as maintenance, replacing parts, gas and oil, and storage costs. If the machine is complicated to operate, there will also be the cost of training your employees to use it.
Indirect costs also take into account opportunity costs. For instance, maybe you favor having a small excavator because it’s less expensive. But it won’t be able to handle big jobs, so you limit your job prospects and opportunities to smaller projects. Or, if you do take on a bigger job, you may need to rent a larger machine to get the job done. That will be another indirect cost.
Endless Calculations? Don’t Forget Safety
Calculating the total cost of ownership can get complex quickly. You must think through all possible future events that will impact the cost of an item. The list of costly scenarios to consider could go on forever.
However, one factor to always include is the cost of safety. Accounting for safety ahead of time will always be more cost effective than being unsafe. Let’s return to our excavator.
Say you choose an excavator that doesn’t have the best safety record but is a bargain. (OK, we know you wouldn’t do this, but let’s just pretend). Imagine the costs you’ll incur if your machine malfunctions and injures someone. Injury costs can add up quickly. A short list of possible bottom-line drainers includes:
- hospital bills
- increased insurance premiums
- paid time off
- rehabilitation costs
- decreases in productivity
Investing the time and money to ensure the utmost safety has many direct and indirect benefits. People won’t get injured, for starters. And, safer companies attract a higher caliber of workers. Employees who feel safe are more productive, more loyal, and more efficient.
Worker well-being is a key factor in the health of a business, so always include what it will cost to maintain safety when figuring out the total cost of ownership.
TCO: A Better Way to Compare
TCO is particularly useful when trying to decide among several options. In our excavator example, we briefly looked at the opportunity cost of choosing a small machine instead of a big one.
But also consider, say, comparing fuel efficiency. A more efficient machine may cost more up front, but you’ll save money in gas over the long run. And don’t forget the costs associated with filling up the tank: the time taken to get the gas and the cost of lost work time while this is being done.
More expensive items typically last longer, so this is a critical factor to consider, especially when you’re looking at an item you’ll be using a lot and over a long period of time. Better made items are usually easier to repair and don’t need to be repaired as often, but parts may be more expensive.
When you think through the total cost of ownership and its components, it very quickly becomes clear that the sticker price is only a starting point for determining the best overall value of an item. This is particularly true when considering a safer option with a higher price tag. The cost of accidents will always outweigh the price of safer equipment.
The Real Bottom Line
The process of calculating the total cost of ownership can be time consuming and challenging. You’ll need to brainstorm all of the factors to include in your assessment. But it’ll be well worth the effort. This is an excellent way to determine what your asset or system is really going to cost you.
There is one certainty that will never waver in this process. When you are thinking through the total cost of ownership and its components, always consider safety.