10.6 Tool: Total Costing

Think back to the car-buying example in the introduction. Do you remember the key takeaway? Hint: Price is not the same as total cost! Yet, many buyers make decisions based on purchase price, which is just the tip of the cost iceberg. For important buying decisions, you really need to calculate your total costs. During your career, you will need to know how to use two common total cost models.

  • . Total landed costs are the sum of all the costs you pay to buy a product and get it delivered to where you want to use it. Here is the equation:

  • . Total cost of ownership (TCO) is equal to total landed costs plus the costs you incur during use and disposal. Imagine, for example, you choose a supplier that offers you a "better" price. Later, however, you find out that the component suffers from an unusually high defect rate. To calculate your TCO, you must include the cost of fixing or disposing of the defective components—as well as the product they were used to build. And, if you didn't find the defect before you sold the product, you may have to include recall costs as well as the cost of lost goodwill. Figure 10.6 shows some of the costs you need to consider when calculating your TCO. As you can see, TCO takes a life cycle approach—that is, what are the relevant costs of the item's entire life cycle? Here is the equation.

Figure 10-6: Major Categories of Total Cost of Ownership Components

Let's take a look at the basic three-step process you will use to calculate total costs.

Step #1: Identify the Relevant Costs

Your first—and most difficult—task is to identify all of the relevant costs/benefits associated with a purchasing decision. Be open and honest. Involve all decision makers who can provide insight into the real costs. Ask the following:

  • What is the real acquisition cost—it is likely much more than the purchase price?

  • What are the year-to-year operating cost implications—i.e., the cost of ownership?

  • What are your end-of-life (i.e., disposal) costs?

Step #2: Define the Timing of the Costs

Remember, money has a time value. That is, a dollar in your hand today is worth more than a dollar you will receive sometime in the future. Thus, if you are buying capital equipment—or anything else with a long life cycle—you need to ask, "When will each of the costs/benefits occur?" The longer a purchased item's life cycle, the more emphasis you need to place on timing (see Figure 10.7) For a simple, one-time total landed costs analysis, all of your costs occur at time "0"—that is, at the time you make your decision.

Figure 10-7: Life Cycle of a Product or Service

Step #3: Calculate the Net Present Value

The net present value () is the sum of the present values of current and future costs/benefits; that is, the value of all of your costs/benefits at today's prices. Let's break that down. Simply put, the NPV is the value all of your costs/benefits would have today. Calculating an NPV allows you to make apples-to-apples comparisons of options that have different cash flows over time. Of course, for total landed costs, you don't need to worry about NPV.

Since you don't own a crystal ball, your biggest challenge in total costing is to accurately estimate all of your costs. Simply put, you've got to guess what will happen in the future. This is always hard. But, it is even more difficult when you are buying new technologies or buying from new suppliers located in distant lands. Ultimately, you need to rely on the estimates of knowledgeable analysts as you build your cost estimates.

To help you see how powerful total costing can be, let's work through a simple example.

Scenario: A new reality show featuring street dancers competing for a million dollar prize just started airing on TV. As a result, boom boxes are now in big demand. As an electronics buyer for a big box retailer, your boss has asked you to find the "right" supplier for these boom boxes. Your boss said, "And by right I mean we want to earn a high margin so we can profit from this fad. And, we don't want to be stuck with inventory when street dancing falls out of favor." You located a supplier in Brazil—Brazil Boom—that seems to be able to meet your boss' requirements. Brazil Boom has quoted you a price of $42.00 per boom box—a price 30% lower than your next best option. Is Brazil Boom the right supplier?

Step 1: Identify Relevant Costs

To get started, you need to calculate your landed costs. After all, you won't be selling a lot of boom boxes in Brazil! You know that transportation is one of the many costs of buying from a global supplier. You do a little research and build Table 10.7

Table 10-7
Relevant Costs for Buying Boom Boxes from a Brazilian Supplier

Step 2: Calculate Your Costs

You quickly realize that many of your costs are stated on a per-container basis. So, you first have to be able to figure out how many boom boxes "fit" on a container. You inquire and find out that the packaged boom box measures 36"X12"X12." You calculate the cube (or volume/3-dimensional space) for each boom box to be 3 cubic feet (i.e., L"XW"XH"/1728).

The supplier's price is based on a 40' Dry Container, which measures about 2,400 cubic feet. You figure you can get about 800 boom boxes on a container (2,400 / 3 = 800). Thus, each container of boom boxes will have a "value" of $33,600 ($42.00 X 800). You will use this value to calculate customs and duties fees!

Now, you are ready to "run the numbers." But, you note that you need to be careful to track which costs are based on containers, pallets, and units. You decide to calculate per container costs and then divide by the 800 boom boxes per container (see Table 10.8).

Table 10-8
Landed Cost of a Brazilian Boom Box

What is your takeaway? Your total cost estimate is $61.05. That is 50% higher than the quoted price. Brazil Boom might not be the right supplier after all. Now, let’s review some basic questions you need to think about.

  • Did you really consider all of the relevant costs? Should you consider costs such as travel costs to the supplier, supplier qualification costs, security costs, or inventory carrying costs. Determining what is relevant—and what isn't—is hard work!

  • Is your analysis robust? Since you know you will be making a recommendation to your boss, you might want to consider alternative scenarios and perform a sensitivity analysis. Under what circumstances would your analysis change? Asking, "What if?" might help you answer tough questions your boss might ask.

  • What can you do to reduce the total cost? For example, at $4,000, your quality control costs are your third largest line item. If you certify Brazil Boom, can you eliminate this cost? Some questions to think about, does every boom box need inspection?

One final thought: Most of the time, you perform a total cost comparison as part of a supplier-selection decision. So, you will be comparing suppliers in different locations and incorporating your results into a multi-criteria analysis.

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