Total Cost of Ownership (TCO) is an analysis meant to uncover all the lifetime costs that follow from owning certain kinds of assets. As a result, TCO is sometimes called life cycle cost analysis.
Asset ownership brings purchase costs, of course, but owning also brings costs due to installing, deploying, using, upgrading, and maintaining the same assets. These after-purchase costs can be substantial. Consequently, for many kinds of assets, TCO analysis finds a significant difference between purchase price and total life cycle costs. And, the difference can be vast when ownership covers an extended timespan. As a result, TCO analysis sends a powerful message to corporate buyers, capital review groups, and asset managers:
Consider TCO instead of the purchase price when making purchase decisions!
Who Uses TCO?
Those who purchase or manage computing systems have had a keen interest in TCO since the late 1980s. At that time, IT industry analysts began publishing studies showing a vast difference between IT systems prices and systems costs. And, not surprisingly, these soon got the attention of IT vendor sales teams and marketers.
Competitors of IBM, for instance, used their own TCO results to argue that IBM systems were overly expensive to own and operate. This kind of argument is possible because the five-year total cost of ownership for substantial hardware and software systems—from any vendor—can be five to ten times the hardware and software purchase price.
Today, TCO analysis supports purchase decisions for a wide range of assets. These include especially items with significant maintenance and operating costs across ownership life. The total cost of ownership is, therefore, at center stage when leaders face purchase decisions for large IT systems, vehicles, buildings, laboratory equipment, medical equipment, factory machines, and private aircraft, for instance.
As a result, TCO for these kinds of assets is a central focus in the following:
- Budgeting and planning
- Asset life cycle management
- Prioritizing capital purchase proposals
- Evaluating capital project proposals
- Vendor selection
- Lease vs. buy decisions
Explaining TCO in Context
Sections below further explain and illustrate the "Total cost of ownership" concept in context with related business concepts from the fields of asset management, budgeting, and cost accounting. These concepts include:
- What is the total cost of ownership? And, who uses TCO?
- TCO analysis covers ownership life, but how long is life?
- How does TCO uncover hidden costs across asset life cycle?
- Do TCO results reflect the analyst's subjective judgment?
- What is the TCO cost model? And, why is the cost model centerpiece of the TCO analysis?
- How do cash flow estimates build the total cost of ownership result?
- A Total cost of ownership analysis example
- What can TCO analysis can tell you? And, what does TCO reveal?
- Why is TCO analysis blind to most business benefits?. And how does TCO find benefits for cost savings?
Cost of ownership analysis attempts to uncover both the "obvious" costs and the so-called "hidden" costs of ownership across the full ownership life cycle of the acquisition. Usually, however, there is room for judgment and different opinions regarding the appropriate lifespan to analyze.
In defining ownership life, owners may consider several "lives" that are in view:
- Depreciable life.
The number of years over which owners charge depreciation expense for an asset is its depreciable life. Accounting standards and local tax laws prescribe what this expense should be each year. Impacts due to this expense include the following:
- Lower book value for the asset.
- Lower taxable income (lower profit)
- Tax savings for owners, due to the lower reported income.
- Economic life.
The number of years for which the asset returns more value to owners 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 asset is actually in service.
All of the above lives may be different, and all may contribute to the owner's judgment as to the length of the ownership life. Also, however, the lifespan for TCO may also depend on the owner's purpose for the analysis.
TCO for Budgeting and Planning Purposes. TCO for Strategic Decision Support.
Firms sometimes declare that "ownership life" is the length of time that ownership has a financial impact. Analysts usually apply this rule in two cases: Firstly, when TCO analysis supports budgeting and planning activities, and secondly when TCO supports strategic decision making. In these cases:
- Ownership life starts when the acquisition begins causing costs. Note especially, this may occur before the asset arrives or goes into service (see the "hidden cost" categories in the next section).
- Ownership life ends when the asset has no financial impact of any kind. "No financial impact" means that all costs due to disposal or decommission have are past, and the asset no longer contributes to a Balance sheet asset account.
TCO for an Arbitrary Number of Years
Alternatively, TCO analysis may cover an arbitrary number of years, for example, three years, five years, or ten years. This approach is usual when:
- The purpose of TCO analysis is to help choose a vendor from competing proposals.
- The TCO analysis helps prioritize capital spending proposals that are competing for funding.
- The actual economic life or service life of the acquisition is uncertain.
- The firm's asset life cycle management policies and practices dictate specific life spans for classes of assets.
Merely naming the cost of ownership subject does not fix boundaries for the analysis. The analyst must still decide and communicate which items belong in the TCO study analysis and why. Consider, for example, the case when TCO analysis applies to a potential IT system acquisition.
- IT TCO comparisons from publishing analysts tend to focus narrowly on costs due to purchase, maintenance, and straightforward operating expenses. Here the emphasis is on comparing different vendor solutions fairly.
- IT TCO analyses from salespeople, consultants, or managers for specific settings usually have a broader scope, aiming at a more inclusive total lifetime cost. These analyses have a more extensive range because This is because these analyses intend to predict budget impacts accurately. Also, these analyses may have to compare TCOs for entirely different kinds of possible actions.
In each of these situations, the TCO analysis serves a different purpose, and each calls for a particular cost model (see next section). When using TCO results, remember that analyst judgment plays a role choosing which cost categories belong in the analysis and which do not. Analysts are free to choose cost classes that best serve the purpose of decision-makers and planners.
In conclusion, when a TCO analysis compares different scenarios or action plans, be sure that all "analysis scenarios" use the same TCO cost model.
The TCO analysis continues by designing a comprehensive cost model that covers the TCO subject through ownership life while supporting the decision maker needs.
Making the step from a complete inventory of "obvious" and "hidden" cost categories, to a comprehensive cost model, requires the analyst to look for specifics in these areas:
- Firstly, the kinds of resources appearing in each of the cost categories.
- Secondly, activities due to ownership, in each of the cost categories.
Why does the analyst invest time and effort in going beyond the list of cost categories to organize them as a cost model? There are two reasons for the model:
- Firstly, remember that a "list" is only that. It does not by itself communicate completeness. In a successful TCO cost model, however, inclusiveness is self-evident to both the analyst and to those who use TCO results.
- Secondly, the cost model structure provides a framework for a very informative kind of cost analysis in its own right. Sections below show how the cost model itself reveals spending issues that are not obvious in the TCO cash flow statement.
For more on cost modeling (resource-based modeling and activity-based modeling) see Business Case Essentials.
TCO Cost Model Example
The cost model in Exhibit 1 below is a two-dimensional matrix whose cells represent categories that could have cost impacts due to ownership. Here, for example, is a TCO model for an IT system acquisition.
|COST MODEL||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|
Exhibit 1. TCO cost model for an IT system acquisition. Rows are resource categories and columns are IT life cycle stages. The contents of each cell are individual resource items. Exhibit 2, below, shows typical cost items for two cells in the Exhibit 1 model.
Note that the vertical axis represents IT resource categories while the horizontal axis represents IT life cycle stages. The model design succeeds when it achieves two objectives:
- Firstly, each axis covers the complete set of cost classes for one dimension: (1) Resources or (2) life cycle stages. Each includes all categories on that dimension that are useful to decision-makers and planners.
- Secondly, the cost categories (or classes) capture apparent costs and also the less-obvious 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 never have to answer questions such as: Why didn't you include this? Or that?
Examples below show that the choice of cost categories for each axis gives the model power for analysis and communication.
Add Individual Resources to Categories
The TCO analyst continues by adding the names of resources to each cell. Resource items that go together in a cell have two characteristics:
- Firstly, owners plan and manage together all resource items in a cell.
- Secondly, various resource items in a single cell may have the same cost drivers.
For a planning an IT System acquisition, two of the model's cells might hold the resource names in Exhibit 2:
Exhibit 2. Resource items in two cost model categories.
Other cells in the same model have similar resource lists. As a result, the full model helps assure TCO analysts and owners that every relevant cost item due to ownership is in view. And, it helps show everyone that the analysis excludes costs that are not due to owning. And, the following sections show how the model serves as a powerful tool for analyzing life cycle costs. And, the following sections explain how the model serves as a powerful tool for analyzing and controlling life cycle costs.
Finally, the cost model helps assure all involved that scenario comparisons are fair and objective. One model can do this if the single model design covers all relevant costs in all scenarios. Of course, some items may have 0 values in one TCO scenario and non-zero values in others. As a result, using one model with the same cost categories for all TCO scenarios shows everyone that comparisons between TCO scenarios are fair.
The cost model (above) provides the TCO analyst with a list of cost items—the contents of all the model cells. The analyst then estimates cost figures for each cost item, for each scenario, looking forward to each year of the analysis.
Exhibit 3 below, for example, shows analyst estimates for just one cost item: Server System Purchase.
Exhibit 3. When the TCO analysis has two scenarios and a 3-year life in view, the analyst makes 6 six cost estimates for each item. Here, the cost item "Server system" purchase appears in two TCO scenarios: Business as Usual and Proposal. Each year's incremental cash flow estimate calculates as:: Incremental Cash Flow= Proposal Estimate – Business as Usual Estimate.
Methods for making these estimates are beyond the scope of this article, but very briefly, the analyst will use several kinds of information to make these estimates. For the IT example, the analyst forecasts cost drivers for each item, under each scenario. These may include, for example, costs due to numbers of users, transaction volumes, and storage space needs. The analyst will also consider information from the vendor, experience with similar systems in other settings, and industry standards and guidelines.
Cash Flow Estimates for Scenario Cash Flow Statements
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.
Exhibit 4 below shows cash flow statement structure. Note especially that many line items from the model are omitted here, to show the structure clearly.
Exhibit 4. A TCO analysis with two action scenarios (Proposal and Business as Usual) has three cash flow statements. And, all three have the same cost items and structure, as in the example above. The analyst, therefore, produces two full value statements (such as the statement above) and one incremental statement. In that statement, each figure calculates as the Proposal scenario estimate less the "Business as Usual" scenario estimate.
The cash flow statements are in one sense children of the cost model. This description is helpful because it is a reminder that cash flow statements take line items from the model and thus retain some of the model's structure. In brief, the cash flow statements have the parent model's vertical axis categories. However, in the horizontal dimension, the statements present a timeline covering the TCO analysis period instead of life cycle stages. The task for the TCO analyst is to estimate cost figures for each year, due to each item, for all scenarios.
Example: Consider Two Possible Scenarios
- Proposal: System Acquisition
- Business as Usual
The "Business as Usual" scenario is an important part of any TCO analysis. It recognizes that owners will still spend money on many of the same IT cost items, even without the new system. As a result, the "Business as Usual" scenario, therefore, serves as a basis for comparison. In fact, the baseline provides the only way to measure cost savings and avoided costs. For this reason, the TCO analyst uses scenarios 1 and 2 to construct a third scenario:
- The Incremental Scenario.
This scenario shows the cost differences between corresponding line items on "Scenario 1" and "Scenario 2." Note again that all three cash flow scenarios have the same 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
And, if the Proposal scenario shows cost savings, or avoided costs, relative to "Business as usual" costs, the analyst can apply investment metrics to the incremental cash flow values, such as:
For more on these metrics, see the articles linked to their names above.
Cost Savings Appear in the Incremental Cash Flow Statement
When Proposal Scenario costs in some areas are lower than the corresponding Business as Usual Scenario costs, the Incremental cash flow statement, therefore, shows cost savings in these areas. As a result, cost savings are the same as cash inflows.
When cost savings are present, the analyst can approach the incremental cash flow statement with investment-oriented metrics such as return on investment, internal rate of return, and payback period. All of these metrics require cash inflows as well as outflows. And, these appear only on the incremental statement.
TCO Cost Savings and Financial Metrics
In that case, a TCO analysis summary might include an array of financial metrics that looks like Exhibit 5.
|3-Year Figures in $1,000||Proposed|
|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)||—||—||$2,365|
|Internal Rate of Return (IRR)||—||—||121%|
|Return on Investment (ROI)||—||—||24.9%|
|Payback Period||—||—||Seven months|
Exhibit 5. Exhibit 5. Comparing financial metrics from two TCO scenarios. Notice that the "investment metrics" apply only to the Incremental cash flow summary.
Negative values (in parentheses) indicate cost savings under the Proposal scenario relative to Business as Usual. Those who want to understand fully the basis for these metrics from must review all three cash flow statements.
The TCO results above seem to show a clear advantage for choosing the Proposal Scenario over Business as Usual. However, the analyst's work continues. After reviewing the above, for instance, questions such as the following will arise.
" If we implement the Proposal Scenario Acquisition...
- Which cost areas represent the most significant risks? And which, therefore, need full management attention?
- Which cost areas are most important in driving overall TCO results?
- What can we do to control and minimize costs?"
The analyst addresses such questions by returning to the cost model itself (next section).
Cost model categories for the cost model rows and columns were chosen to represent cost areas that need careful planning and control over a three year period. Once the scenario cash flow estimates exist (previous section), the analyst can use the model to show cost dynamics not easily seen in the cash flow statements.
Here, the cost model cells in Exhibits 6A, 6B, and 6C hold 3-year totals for items in each cell. The figures that go into each sum, of course, come from the cash flow statements.
Proposal System Acquisition Scenario
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs||Total||% of|
|NW & Comm||255||1,082||892||2,229||15.6%|
|% of TCO||12.8%||50.3%||36.9%||—||100.0%|
Exhibit 6A. Three-year cost estimates for the Proposal scenario.
Business as Usual Scenario
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs||Total||% of|
|NW & Comm||146||543||459||1,149||6.7%|
|% of TCO||5.9%||55.7%||38.4%||—||100.0%|
Exhibit 6B. Three-year cost estimates for the "Business as Usual" scenario.
Incremental Cash Flow (Proposal Less Business as Usual)
|$ in 1,000s||Acquisition Costs||Operating Costs||Change Costs|
Exhibit 6C. Exhibit 6C. Total incremental costs for each cell of the cost model. Each cell represents the value from a cell in Exhibit 6A, less the corresponding cell value in Exhibit 6B. Negative incremental values in parentheses indicate cost savings under the "Proposal" scenario.
The analysis 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.
TCO Analysis Can Uncover "Hidden" Costs of Ownership
TCO can bring out so-called "hidden" costs of ownership.
In this example, owners chose to include all the essential costs from system acquisition, including labor costs for people who use or support the systems.
When deciding whether or not to acquire a new system, it is easy to focus excessively on hardware and software costs. Leaders should focus instead, however, on the Personnel costs that come with the system. These "People costs" are 68.8% of the TCO. As a result, how the firm trains, employes, and manages these employees will ultimately play a more significant role in determining the actual cost of ownership than other factors, such as the choice of HW or SW vendor.
Potential Problem Alerts
TCO can help spotlight potential cost problems before they become real problems.
In the IT world, for instance, change costs can often exceed forecast and budget. These typically include expenses for upgrading, adding capacity, reconfiguring, adding users, migrating to different platforms, and so on.
All of the change cost items in this model could appear instead under either of two cost column headings, Acquisition or Operating costs. Here, however, the analysts chose to focus on change costs by giving them a Change cost column of their own. As a result, it is easier to measure, plan, and control expenses specifically due to change. Note especially in this example, change costs represent between 35 and 40% of total cost of ownership in both scenarios.
Identify Cost Savings and Avoided Costs
An Incremental Cash Flow Statement Finds Cost Savings and Avoided Costs.
In this example, Proposal Scenario costs are more substantial than Business as Usual Costs in almost all cells of the cost model. "Business as Usual" costs are higher in only two cells: Personnel Operational Costs and Personnel Change Costs. Here, however, the Proposal Cost Savings show up as substantial negative numbers in the incremental cost model summary. Those two cost savings are more than enough to give the Proposal Scenario a considerable TCO advantage.
TCO analysis is not a complete cost-benefit analysis because TCO tries to uncover ownership costs, but it is blind to other kinds of business benefits due to acquisitions, projects, or initiatives. Since TCO sees only costs, it takes no account of benefits such as higher sales revenues, faster information access, greater operational capability, competitive gains, or higher product quality.
As a result, when TCO is the primary focus in decision support, decision-makers are assuming the following:
- Benefits other than cost savings are more or less the same for all options.
- And, the options differ only in cost.
TCO analysis itself says nothing about the validity of that assumption. When the owner believes different solutions may bring different business benefits, a complete cost-benefit business case analysis may be appropriate.
In brief, TCO analysis can find only two kinds of business benefits: cost savings and avoided costs. Either of these benefits can show up when comparing TCO for different scenarios. The example above shows, for instance, that when TCO is less under a "Proposal" scenario and greater under a "Business as Usual" scenario, the results are cost savings under the "Proposal" scenario.