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.

• 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.

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 expenses. 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 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.

To calculate the TCO of an asset, we should consider every expense that will incur in association with the asset throughout its useful life. 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 value 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 + – Salvage value

Inscribe service cost as the sum of operating cost and maintenance cost.

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:

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.

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.

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 vendors.

Advantages

• 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 management 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

Challenges:

• Time-consuming
• Terminologies vary between industry
• Valuation of intangible assets using TCO is difficult
• Does not consider the risk associated with the alternatives
• Practical application is limited

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 –

• Process Costing
• Cost of Goods Sold (COGS)
• Life Cycle Costing