The total cost of ownership can be defined as total direct and indirect costs (such as operating costs, acquisition costs, and personnel costs, etc.) associated with the product over the entire lifetime of the product.
The concept of cost of ownership is very important for businessmen to understand, as multiple costs are associated with the product such as there is the cost of maintenance in addition to the cost of purchase of the product. The total cost of ownership can make huge differences between the price of a product from two different sellers.
The meaning of the Total Cost of Ownership
It is believed that the Total cost of analysis (TCO) is introduced by the Gartner Group in the year 1987. However, the concept of the Total Cost of Ownership is also found in the manual of the American Railway Engineering Association used as a part of final financial calculations.
In simple words, it is the sum of asset value and all the other direct and indirect costs associated with the product. The total cost of ownership provides financial information about the product’s cost over some time.
When a decision of buying an asset is made, both prices such as the price for a short period of time called purchase price and long-term price called total cost of ownership is considered. The value of the total cost of ownership is considered by companies before making any type of investment.
A thorough analysis of the total cost of ownership is done. This includes both the initial purchasing cost of the asset and all the direct and indirect expenses.
Direct expenses are easy to obtain as companies keep the documents of direct expenses, but it is difficult to calculate indirect expenses as there is no proper documentation is made for the indirect expenses.
The use of the total cost of ownership became popular in mid-eighties when IT sector bloomed and started becoming an essential part of the organizations, and it became essential to calculate the expenses for the hardware and software acquisition.
The managers found that the cost of supporting hardware and software is 5 to 10 time more than the purchase price.
Later the total cost of ownership is used for various assets such as manufacturing equipment, vehicles, buildings, etc. The calculation of the total cost of ownership is useful in making important decisions. For example, whether it will be beneficial to lease a property or buy one.
Key Components of Total Cost of Ownership:
There are following five components, which are included in the analysis of Total Cost of Ownership:
- Operating Costs
- Physical Hardware Costs
- Personnel Costs
- Accounting Contributions
- Cost of Safety
Let us learn about all these costs one by one
1) Operating Costs:
The operating cost includes various costs such as initial training cost, direct operator cost, and utility costs, etc. These costs are spent on the subscription or service required to make the asset usable for the business purpose before starting making any profit from it.
2) Physical Hardware costs:
Physical cost or acquisition cost is the basic cost of the asset without the inclusion of taxes. However, costs like discounts, commissions, closing costs, and purchasing incentives are included in the acquisition cost of the asset.
In addition to this, this cost also includes the costs of graduation required for the utilization or installation of the asset or the purchase of one-time peripheral equipment required for the installation process, etc.
3) Personnel Costs:
This component of the total cost of ownership includes costs of administrative staff, facility housing the equipment, support personnel, operators, troubleshooting labor for maintenance purposes, etc.
4) Accounting Contributions:
The total cost of ownership not only include the cost, but it also includes the revenue flow, increment in savings created by making a capital investment.
5) Cost of Safety:
The calculation of the total cost of ownership for an asset is a complex process. You are not only required to calculate the direct and indirect cost associated with the purchase, but you also required to keep various probable events that can occur in the future in your mind. The one most important cost that one must not forget to include is the cost of safety.
Therefore, you must invest sufficient time and money to ensure safety so that you can avoid future big expenses. The probable costs that can impact your total revenue generation include hospital bills, increased insurance premiums, rehabilitation costs, decreased productivity, paid time off, etc.
Why calculate the total cost of ownership?
When an organization purchase an asset or property, the total price paid by the buyer is not only the price of the asset, but it also includes other prices such as shipping prices, installation price, etc. therefore, by calculating the total cost of ownership you get a clear picture of how much you are going to spend and whether the deal is profitable for you or not.
In addition to this, you can also make the use to compare the two deals. You can determine which deal is profitable for you after you know the total cost of ownership for both.
Let us understand this with a simple example. A middle-class man has a total saving of $2000, and he decides to purchase a car. When he searched online to find out the car of his choice, he found two cars that he liked.
The price of the first car of brand XYZ is $1800 and the price of the second car of brand ABC is $1000. In this scenario, which car the person should buy so that his spending does not exceed his total saving?
To decide which car to buy the person should calculate the total cost of ownership for both cars as there are various costs such as taxes, shipping cost, insurance cost, maintenance cost, etc. after calculating all additional cost the total cost that the person would spend in buying car of brand XYZ would be $2700, and the cost of buying a car of brand ABC would be $1500.
Hence, buying a car of brand ABC would be the right choice for the person.
In addition to this, the calculation can be used when making decisions like leasing or buying, budgeting and planning, selection of vendor, asset life cycle management, evaluating capital project proposals, prioritizing capital purchase proposals, etc