What is Total Cost of Ownership?
The total cost of ownership (TCO) is a management accounting concept that derives an asset’s total cost during its useful life. It includes the purchase price, maintenance and operational cost that will incur during the asset’s lifespan.
Analyzing alternatives from a long-term perspective will result in selecting practical, affordable, and prolific options. Hence, TCO helps to take a rational approach to long term planning.
Table of contents
- Total cost of ownership (TCO) refers to the lifetime cost of buying an asset. In simple terms, we can say that it is the total monetary cost attributed to an asset spanning from the purchase planning to its disposal.
- TCO analysis helps to disclose all direct, indirect as well as any hidden costs associated with a purchase. Therefore, it’s helpful to examine whether a cost-effective product is as economical as you think.
- The formula to calculate the TCO is to add the initial purchase value to direct, indirect and other hidden costs. The value so arrived is then subtracted from a projected resale/ residual value at the end of the asset’s lifespan.
- These costs may change depending on what you’re buying and what’s your purpose of the purchase. Also, hidden cost varies with the asset type.
How Total Cost of Ownership Works?
The TCO analysis is a handy guide that helps buyers and sellers define the actual cost of purchasing any asset. The method is widely in use to determine the lifetime costs involved with purchasing an asset or investment. By calculating the TCO, entities can find new ways to save money in the long-term scenario.
Most products are accompanied by a series of costs, including an upfront short-term purchase cost and many hidden long-term expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.. As a result, the overall cost throughout the life cycle of an asset may be larger than anticipated if the TCO is not analyzed. For example, the TCO for acquiring new software to automate a segment of operations will combine all direct and indirect expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses. incurred in the process till it remains in use.
The cost of new software could include the cost of training, hardware, implementation, customization and data migration etc., apart from the up-front software purchase cost. Thus, TCO is an essential element of the return on investment (ROI) calculation.
Total Cost of Ownership Formula
To calculate the TCO of an asset, we should consider every expense that will incur in association with the asset throughout its useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.. Essentially, we will calculate the price of buying the product plus later expenses minus the remaining value of the property.
TCO calculation considers the initial investment and collects maximum information to include costs related to continued asset usage. Treat the list of terminologies listed in the below equations as a basic introduction of the possible costs. The TCO analysis varies between entities. Note that not all of these aspects are necessarily accountable for all purchases.
Total Cost of Ownership Formula = Purchase Price + Cost incurred during the useful life
Expand the equation by segregating acquisition cost and salvage value attributable to purchase price. Salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. refers to the book value of an asset at any particular point after adjusting for depreciation.
= Acquisition cost + Service cost – Salvage value (Remaining value)
We can inscribe costs incurred during the useful life as service cost or operating cost.
= Acquisition cost + [Operating cost + Maintenance cost] – Salvage value
Inscribe service cost as the sum of operating cost and maintenance cost.
|Acquisition cost||Operating cost||Maintenance cost||Salvage value|
|• Purchase price/buying price||• Insurance cost||• Equipment downtime||• The remaining cost is derived using depreciation calculation|
|• Research cost||• Fuel or energy cost||• Preventive & Routine maintenance cost||• Can be zero|
|• Logistics cost||• Administration cost||• Cost of repairing spare parts||• Equivalent to resale value|
|• Installation cost||• Employee training|
Below is a solved example of the total cost of ownership, but in businesses, the numbers tend to be huge, requiring calculators.
Dave is the owner of a metallurgic factory. He wants to buy new machinery and is currently comparing two models. One is pre-owned, but its retail price is much less expensive than the newest model in the market.
The difference is pretty big in the purchase price, but he decides to calculate the TCO anyway. Here’s the result:
|Particulars||Used Model||New Model|
|Residual value/Resale value||(13,000.00)||(21,000.00)|
Dave discovers that the used model is more expensive than the new one because of hidden costs. While the operational costs are mostly the same, the maintenance, logistical and residual values vary.
Since the resale value of a new model is higher than the old model, he can sell it for a much better price later. So, Dave decides to buy the latest model to save money.
Total Cost of Ownership in Cars
If you ever owned a car, you know that the retail value is just a tiny portion of the total expense associated with it. Therefore, whenever you purchase a vehicle, think about these points:
- Which car model is the most fuel-efficient?
- Does the make and model of your car affect how much you pay for insurance?
- Is the car pre-owned or new? Older models may need repairs more often.
- Does the car have a warranty? What does the car warranty cover?
- How soon will the vehicle’s value depreciate? Is it already depreciated?
In certain situations, a used model may appear to be a good deal at first, but the TCO of the car may significantly be more due to these factors. In addition, with an older model, your insurance may be substantially more. Simultaneously, you may need to replace several parts of the car, and you may not achieve a fair resale value in the end.
Total Cost of Ownership in Procurement
Another specific instance that demonstrates the importance of TCO is procurement. For businesses minimizing the TCO becomes a continual aim if they are not dealing with a one-time purchase. Besides all of the points cited so far, we might still need to think about the logistics associated with a purchase.
Before signing a contract with a supplier, the manufacturer should take the following aspects into account:
- How quickly can the business collect the raw materials for production so that there will be no delay in production and associated downtime.
- Downtime is the cost related to the lost production whenever a business needs to make repairs. It’s not the actual money spent, but how much a business does not gain due to a temporary operational disruption when an asset is undergoing maintenance.
- Buying in bulk may result in a better upfront cost but will increase the holding/warehousing costs.
- Long-term contracts may lower the cost of goods, but will the sales suffer as a result of the lack of flexibility?
- Unreliable suppliers may hurt the business even if their price is much lower than the competitors. They may increase costs related to downtime (by being late) or maintenance (may provide low-quality products).
Examining these factors can provide a more accurate picture of TCO and offer the business more leverage when negotiating with potential vendorsVendorsA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers..
Benefits and Challenges of TCO
- Comprehensive analysis of all potential costs involved with an asset purchase over its lifetime
- Providing a framework to compute ROI
- Ascertaining the best value asset from alternatives
- Supporting strategic cost managementCost ManagementCost management is an integral part of business management that works on the basis of estimates, where various activities such as data collection, data analysis and mechanisms, process evaluation, and event reporting are carried out so that the decision-maker can plan and control the organization's budget requirements, allowing the decision-maker to make informed decisions. by saving on avoidable costs
- Enriching decision-making and operational efficiency
- Allowing analysis of a single unit of business as well as the whole of it
- Terminologies vary between industry
- Valuation of intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. using TCO is difficult
- Does not consider the risk associated with the alternatives
- Practical application is limited
The formula to calculate the total cost of ownership is to add the initial purchase value to all hidden costs and subtract a possible resale value or residual value in the end.
TCO refers to an accounting method used for calculating the cost of an asset. TCO method collects all possible costs or expenses pertaining to the asset at the time of purchase and during its useful life.
It determines how expensive it is to possess an asset. Therefore, TCO calculation is essential to businesses because it helps in the cost planning.
Predominantly, TCO includes total acquisition cost, operating cost and maintenance cost.
This article has been a guide on the Total Cost of Ownership. Here we discuss its definition, key takeaways, benefits and challenges of TCO, how to calculate it, along with practical examples. You can learn more about accounting from the following articles –