Total Cost of Ownership TCO Explained
Definitions, Meaning, and Example Calculations
Business Encyclopedia ISBN 978-1-929500-10-9. Revised 2014-04-17.
Acquiring certain assets brings purchase costs but these can be overshadowed by other large costs that appear during a long service life. TCO analysis attempts to uncover both the obvious costs and the "hidden" costs of ownership.
Total Cost of Ownership (TCO) is an analysis meant to uncover all the lifetime costs that follow from owning certain kinds of assets. Ownership brings purchase costs, of course, but ownership can also bring costs for installing, deploying, operating, upgrading, and maintaining the same assets. For this reason, TCO is sometimes called life cycle cost analysis. For many kinds of acquisitions, TCO analysis finds a very large difference between purchase price and total long term cost, especially when viewed across a long ownership period.
who purchase or manage computing systems have had a high interest in
TCO since the 1980s, when the potentially large difference between
IT systems prices and systems costs started drawing the
attention of the IT consulting community and IT vendor marketers.
Competitors of IBM, for instance, used TCO analysis to argue that an IBM
computing environment was an overly expensive ownership
proposition. The five year cost of ownership for major hardware and
software systems—from any vendor—can be five to ten times the hardware
and software purchase price.
Today, TCO analysis is used to support acquisition and planning decisions for a wide range of assets that bring significant maintenance or operating costs across ownership life. Total cost of ownership (TCO) analysis is center stage when management is faced with acquisition decisions for computing systems, vehicles, buildings, laboratory equipment, medical equipment, factory machines, and private aircraft, for instance. Today, TCO analysis for these kinds of assets is in fact a central concern in the following:
- Budgeting and planning.
- Asset life cycle management.
- Prioritizing capital acquisition proposals.
- Vendor selection.
- Lease vs. buy decisions.
• TCO analysis covers ownership life, but how long is life?
• How does TCO uncover hidden costs across asset life cycle?
• Do TCO results results reflect the analyst's personal judgement?
• The TCO cost model: Centerpiece of the analysis
• Total cost of ownership is based on cash flow cost estimates
• Total cost of ownership analysis illustrated with an example
• What TCO analysis can tell you.
• TCO analysis is blind to business benefits (except for cost savings, sometimes)
TCO analysis covers ownership life or life cycle, but how long is life?
Cost of ownership analysis attempts to uncover all of the obvious costs and all of the "hidden" costs of ownership across the full ownership life or life cycle of the acquisition. Usually, however, there is room for judgement and different opinions regarding the appropriate lifespan to analyze. In specifying ownership life or life cycle, owners may very well take notice of several other "lives" that are in view:
- Depreciable life: The number of years over which an asset will be depreciated. In each year of this life, a depreciation expense is calculated (as prescribed by local tax laws and accounting standards), which lowers reported income while creating a tax savings.
- Economic life: The number of years in which the acquisition returns more value to the owner than it costs to own, operate, and maintain. When these costs exceed returns, the acquisition is beyond its economic life.
- Service life: The number of years the acquisition will actually be in service.
All of the above lives may be different and all may contribute to the owner's judgement as to the length of the ownership life. Beyond this, however, the specified TCO lifespan may depend on the owner's purpose for the analysis:
1. When the TCO analysis is performed to support budgeting and planning, or to support strategic decision making, ownership life for the analysis is normally taken as the complete length of time that ownership has financial impact:
- Ownership life begins when the acquisition begins causing costs. This may include costs that occur before the actual arrival or use of the acquisition (see the "hidden cost" categories in the next section).
- Ownership life ends when the asset is no longer causing costs and has no continuing financial impact of any kind. This means that all costs of disposal or decommission have been paid and the asset is no longer carried in an asset account on the company's balance sheet.
2. Alternatively, TCO analysis may be designed to cover an arbitrarily specified number of years, for example, 3 years, 5 years, 10 years, and so on. This approach is usual in these situations:
- TCO analysis is performed to choose a vendor from competing proposals, or to prioritize competing capital acquisition proposals.
- The actual economic life, or service life of the acquisition is uncertain.
- The organization's asset life cycle management polices and practices dictate specific life spans for classes of assets.
How does TCO uncover hidden costs across asset life cycle?
TCO analysis begins when the owner or analyst identifies (a) the specific resource or asset to be acquired, and (b) specifies the ownership life as described in the previous section. The ownership life is given as a number of years with a known starting date and ending date.
TCO analysis continues when the owner or analyst identifies all the cost categories that can be expected to have cost impacts from ownership. TCO analysis is successful when the owner includes two major kinds of cost categories that will see cost impacts across ownership life, obvious costs and "hidden" costs.
1. Obvious costs in TCO analysis
Obvious costs in TCO are the costs familiar to everyone involved during planning and vendor selection, such as:
- Purchase cost: The actual price paid.
- Maintenance costs: warranty costs, maintenance labor, contracted maintenance services or other service contracts.
2. Hidden costs in TCO analysis
The so-called hidden costs are the less obvious cost consequences that are easy to overlook or omit from acquisition decisions. Costs of this kind can be very large and real, nevertheless. All belong in the TCO analysis if they do indeed follow from the decision to own something and they are material (large enough to matter). "Hidden" costs may include:
- Acquisition costs: the costs of identifying, selecting, ordering, receiving, inventorying, or paying for something.
- Upgrade / Enhancement / Refurbishing costs.
- Reconfiguration costs.
- Set up / Deployment costs: costs of configuring space, transporting, installing, setting up, integrating with other assets, outside services.
- Operating costs: for example, human (operator) labor, or energy/fuel costs.
- Change management: costs: for example, costs of user orientation, user training, workflow/process change design and implementation.
- Infrastructure support costs: for example, costs brought by the acquisition for heating/cooling, lighting, or IT support.
- Environmental impact costs: for example, costs of waste disposal/clean up, or pollution control, or the costs of environmental impact compliance reporting.
- Insurance costs.
- Security costs:
- Physical security, for example, security additions for a building, including new locks, secure entry doors, closed circuit television, and security guard services.
- Electronic security, for example, security software applications or systems, offsite data backup, disaster recovery services, etc.
- Financing costs: for example, loan interest and loan origination fees.
- Disposal / Decommission costs.
- Depreciation expense tax savings (a negative cost).
The list of hidden cost categories above could of course be extended for many kinds of acquisitions.
TCO analysis uncovers obvious and hidden costs when the analyst anticipates (plans for the possibility of ) cost impacts in all the above categories and sometimes additional categories. Guidance and suggestions for identifying all relevant cost categories may come from a number of places, including:
- The owner's own experience with other acquisitions and ownership in the current environment or another.
- The company's policies and standard practices for asset life cycle management.
- Industry standards.
- Vendor recommendations and vendor experience.
- Published TCO analyses from other analysts or publishing consultants.
- Project plans for implementation, which should include resource requirements including labor and, ideally, a complete work breakdown analysis.
- The organization's long range business plan, which should include the organization's business model, projected business volume, revenues, and distribution of expected costs by major categories. The business plan should also recognize expected important trends in the above areas, as well as trends in factors such as inflation, costs and prices, customer demand, technology, and government regulation.
Do TCO results reflect the analyst's personal judgment?
Simply naming the cost of ownership subject does not set boundaries for the analysis. You must still decide and communicate which costs belong in the analysis and why. Consider the case when TCO analysis is applied to potential IT system acquisitions:
- IT TCO comparisons from publishing analysts tend to focus more narrowly on purchase price, maintenance, and very direct operational costs. Here the emphasis is on "Apples-to-Apples" comparability between different vendor solutions.
- IT TCO analyses from sales people, consultants, or managers for specific settings tend to have a broader scope, aiming at a larger, more inclusive total lifetime cost. Here the emphasis is on predicting budget impacts accurately and, sometimes, on comparing the total costs for quite different kinds of proposed actions.
In each of these situations, the TCO analysis serves a different purpose, and each calls for its own TCO cost model (see next section). When using TCO results, remember that analyst judgment plays a role choosing which cost categories to include in the analysis and which to exclude. Analysts are free to choose cost categories that best serve the purpose of decision makers and planners. When the TCO analysis compares different scenarios or action plans, be sure to verify that all were evaluated with the same TCO cost model.
The TCO cost model: Centerpiece of the analysis
The TCO analysis continues with the design and completion of a comprehensive cost model that completely covers the subject of the case through the entire ownership life, and which supports the purpose and needs of decision makers.
Making the step from a complete inventory of obvious and hidden cost categories, to a comprehensive cost model, requires the analyst to look for specific ...
- Kinds of resources used in each of the obvious and hidden cost categories.
- Activities required as a result of ownership, in each of the obvious and hidden cost categories.
Why does the analyst invest time and effort in going beyond the list of cost categories to create a cost model? There are at least two reasons:
- First, remember that a list is only that—a list—that does not by itself communicate completeness. In a successful TCO cost model, however, completeness should be self evident, to both the analyst and to those who rely on the analysis results for decision support and planning.
- Secondly, the cost model structure provides a framework for a very informative kind of cost analysis, the results of which are not so easily seen in the projected cash flow statement.
[For a more complete introduction to cost modeling, including resource-based modeling, activity-based modeling, and cash flow cost estimates based on the model, please see Business Case Essentials .]
The cost model, as presented here, is simply a two-dimensional matrix, whose cells represent cost categories. Here, for example is a model for total cost of ownership analysis of a proposed IT system acquisition.
|Acquisition Costs||Operating Costs||Change Costs|
|Software||Obvious costs||Obvious costs||Hidden costs|
|Hardware||Obvious costs||Obvious costs||Hidden costs|
|Personnel||Hidden costs||Hidden costs||Hidden costs|
|NW & Comm||Hidden costs||Hidden costs||Hidden costs|
|Facilities||Hidden costs||Hidden costs||Hidden costs|
Note that the vertical axis represents IT resource categories, and the horizontal axis represents IT life cycle stages. The model design is successful if it achieves two objectives:
- Each axis covers the complete set of categories for that dimension that are useful to decision makers and planners.
- The cost categories will capture the obvious costs but also the less-obvious, or "hidden" costs.
The two axes, that is, should convey self-evident completeness. If they do, there should be no unpleasant cost "surprises" later, during implementation, and the analyst should not have to answer questions such as: Why didn't you include this? Or that?
As the example below shows, it is the choice of cost categories for each axis that gives the model its power as an analysis tool and as a communication tool.
The analysis continues by adding the names of resources to each cell. Resource items that go together in a cell should be those that are planned and managed together, and which may have common cost drivers. For a planned IT System acquisition, two of the model's cells might hold these resource names:
Acquisition / Hardware Costs
• Server system purchase
Operating Costs / Personnel
• Administrative labor
Other cells in the same model are similarly populated with resources. The full model provides an effective tool for assuring TCO case builders and case recipients that every important cost item is included and that everything irrelevant is excluded. As the following sections show, it also provides a uniquely powerful tool for analyzing life cycle costs.
The cost model also provides a means for assuring all involved that different proposals, or different action scenarios were compared fairly. The model should be designed so that one model covers all relevant costs in all scenarios. Of course some items may have 0 values in one scenario and non zero values in others, but by applying one model with the same cost categories to all scenarios, there should be no question that the TCO comparison between scenarios is fair.
Total cost of ownership is based on cash flow cost estimates
The cost model (above) provides the total cost of ownership analyst with a list of cost items—the contents of all the model cells. The analyst must then estimate cost figures for each item, for each scenario under consideration, for each year covered by the analysis
Here, for example, are one analyst's estimates for just one cost item (Server System Purchase):
Methods for making these estimates are beyond the scope of this encyclopedia entry, but briefly, the analyst will base these figures on several kinds of information. For the IT example, the analyst will forecast cost drivers for each item, under each scenario, (for example, numbers of users, transaction volume, storage space requirements, and so on). The analyst will also base the estimates on vendor-provided information, experience with similar systems in other settings, and industry standards and guidelines.
With cost categories and cost items from the cost model, the analyst can build the primary analytic tools in the TCO study: cash flow statements for each scenario. The example below shows cash flow statement structure (many line items from the model are omitted from this example to show the structure more clearly).
The cash flow statements are in a sense children of the cost model, in that the statements take their line items from the model and retain some of the model's structure. The cash flow statements have the parent cost model's vertical axis categories, but in the horizontal dimension, the statements present a time line covering the TCO analysis period. The task for the TCO analyst is to estimate cost figures for each year, for each item, for all scenarios.
Here, the analyst is considering two possible scenarios:
- Proposed System Acquisition
- Business as Usual.
The Business as usual scenario is an important part of any TCO analysis. It recognizes that even if the company does not acquire the new system, it will still spend money on many of the same IT-related cost items. Only with a baseline, or Business as Usual scenario for comparison, can any cost savings or avoided costs be found and measured.
For this reason, the TCO analyst will also construct another scenario, (3) The Incremental Scenario, which shows the cost differences between corresponding line items on scenarios (1) and (2). All three cash flow scenarios, however, will have the same cash flow statement structure (as above) because they all derive from the same cost model.
Finally, the TCO Analyst will use the "bottom lines" of the cash flow statements to compare scenarios using standard financial metrics, such as 3-year net cash flow, net present value, total capital costs (CAPEX), total operating expenses (OPEX) and, of course, 3-year total cost of ownership.
Moreover, if Proposal Scenario costs are lower in some areas than the corresponding Business as Usual Scenario costs, the Incremental cash flow statement will show cost savings in these areas. Cost savings can be treated as cash inflows, allowing the analyst to extend the analysis with investment-oriented metrics such as return on investment, internal rate of return, and payback period. In that case, the TCO analysis might be summarized with an array of financial metrics that looks like this:
3-Year Figures in $1,000s
|Total Cost of Ownership||$14,256||$17,258||$(3,002)|
|Capital Expenses (CAPEX)||$1,219||$707||$511|
|Operating Expenses (OPEX)||$13,037||$16,550||$(3,513)|
|Net Cash Flow||—||—||$2,981|
|Net Present Value @8% (NPV)||—||—||$2,365|
|Internal Rate of Return (IRR)||—||—||121%|
|Return on Investment (ROI)||—||—||24.9%|
|Payback Period||—||—||7 months|
Negative values (in parentheses) indicate cost savings under the Proposal scenario relative to Business as Usual. Those who want to understand fully where these metrics come from will of course have to have access to the three cash flow statements.
The TCO results above seem to show a clear advantage for choosing the Proposal Scenario over Business as Usual. However, the TCO analyst's work is not yet completed. After reviewing the above, for instance, questions will arise such as this: If we choose to implement the Proposed System Acquisition ...
- Which cost areas represent the greatest risks, and therefore need to be managed most carefully?
- Which cost areas are most important in driving overall TCO results?
- What can we do to minimize costs?
The analyst can begin to answer such questions by returning to the cost model itself (next section).
Total cost of ownership illustrated with an example
Cost model categories for the cost model's rows and columns were chosen to represent cost areas that need careful planning and management during the three year period in view. Once the scenario cash flow estimates are made (previous section, above), the model's structure can now be exploited to show cost dynamics that may not be easy so easy to see in the cash flow statements.
Here, the cost model
cells are filled with the 3-year totals for items in each cell. The
figures that go into each sum, of course, come from the cash flow
Proposal system acquisition scenario
|$ in 1,000s||Acquisition
|NW & Comm||255||1,082||892||2,229||15.6%|
|% of TCO||12.8%||50.3%||36.9%||—||100.0%|
Business as Usual Scenario
|$ in 1,000s||Acquisition
|NW & Comm||146||543||459||1,149||6.7%|
|% of TCO||5.9%||55.7%||38.4%||—||100.0%|
Incremental Cash Flow (Proposal less Business as Usual)
|$ in 1,000s||Acquisition
The analysis summarized in these three tables provides a wealth of useful information that management can put to good use, regardless of which scenario they choose to implement. The next section discusses just a few of the messages brought out by the cost model analysis.
What TCO can tell you
The TCO analysis above is meant to show that:
- TCO can bring out so-called "hidden" costs of ownership.
In this example, management chose to include all the important costs caused by system acquisition, including the labor costs of people who use or support the systems.
When deciding whether or not to acquire a new system, it is easy to become distracted by hardware and software cost, but in fact the "People" costs that come with the system are 68.8% of the very large TCO. How well these people are trained, employed, and managed will be far more important in determining actual cost of ownership than other factors, such as the choice of HW or SW vendor.
- TCO can put the spotlight on potential cost problems before they become problems.
In the IT world, for instance, "Change costs" are typically under planned and over budget (these are the costs of upgrading, adding capacity, reconfiguring, adding users, migrating to different platforms, and so on).
All of the change cost items from this model could have appeared under "Acquisition" or "Operating" cost columns, but by specifically culling out the change costs, and giving them a column of their own, they can be planned and controlled more easily. In this example, change costs represent between 35 and 40% of total cost of ownership in both scenarios.
- An Incremental Cash Flow Statement Finds Cost Savings and Avoided Costs.
In this example, Proposal Scenario costs are larger than Business as Usual Costs in all cells of the cost model except two: Operational Costs for Personnel and Change Costs for Personnel. Here, however, the Proposal Cost Savings show up as very large negative numbers in the incremental cost model summary. Those two cost savings are more than enough to give the Proposal Scenario a large TCO advantage.
TCO analysis is blind to business benefits (except cost savings, sometimes)
TCO analysis is not a complete cost benefit analysis, however. TCO pays no attention to many kinds of business benefits that result from acquisitions, projects, or initiatives, such as increased sales revenues, faster information access, improved operational capability, improved competitiveness, or improved product quality. When TCO is the primary focus in decision support, it is assumed that such benefits are more or less the same for all decision options, and that management choices differ only in cost.
TCO may be used as shown above, however, to find the benefits cost savings and avoided costs. These benefits show up when TCO for one scenario is compared to TCO for another scenario. As in the example above, when TCO is less under a "Proposal" scenario than TCO under a "Business as Usual" scenario, the result is an expected cost savings under the proposal scenario.
By Marty Schmidt. Copyright © 2004-.