Companies should not focus exclusively on purchase prices while making an investment decision. There are also indirect or hidden costs that come into effect just after the initial purchase of the tangible or intangible asset (IT software and hardware, machinery, vehicles, and so on). Total cost of ownership (TCO) aggregates both direct and indirect costs. It evaluates the full cost of a decision by assessing factors like service, energy, maintenance, and training costs.
The concept of TCO was born in the late 1980s. Used originally by the Gartner Group, it has since been shifted to other contexts by some means or the other. Today, TCO is being used by an increasing number of companies. Its core principle is to identify well-known cost drivers as well as the so-called “hidden costs”—ideally directly at the beginning of any investment decision process.
What is TCO about?
TCO estimates the total cost of goods, services or construction work. It combines the final purchase price as well as all extra costs that might accumulate in the asset’s lifetime.
For example, let us think about buying and using a car. Because of the tons of alternatives available, normally it is not such an easy decision to select a specific make and model. If a prospective car buyer focuses only on purchase prices in his favored vehicle class, he will not necessarily get the best value for money. He should also take into account the on-road price, insurance and vehicle licenses, regularity of services, fuel consumption, frequency of the need for repairs, and a convincing resale price.
When should the TCO approach be used?
The concept of TCO is quite easy to adapt and use in all stages of procurement. It is not limited to investments like buying cars or leasing printers, but can also be used to estimate the total costs of intangible assets, like software in its lifetime.
For example, several researchers have found that the management and maintenance of software systems represent more than 50% of the total lifecycle costs. Losses in productivity caused by downtimes or malfunctions account for about 15–20% annual costs. So, considering these, the direct costs of buying specific software licenses play a relatively small role in the overall context.
The possible advantages of using the TCO concept in your company:
- TCO estimates the costs, advantages, and risks of a planned investment project.
- TCO makes different investment alternatives comparable with each other on a similar cost basis.
- TCO helps consumers to select the best supplier—not simply by comparing purchase prices, but by analyzing the overall lifecycle costs of competing bids.
- TCO enables competing contractors to demonstrate all the (long-term) advantages and values of their offer, which might overcompensate for the disadvantage of an above-average initial selling price.
Potpourri of hidden costs: Direct versus indirect costs
The initial purchase price of goods and services is usually well known. But what about all the other functional costs related to the investment? To exemplify the approach, just think of an iceberg as a symbol of those lifecycle costs: The purchase price is similar to the tip of the iceberg. But a lot of cost positions are also hiding under the water surface and need a closer look. A TCO calculation is complete and provides useful results only if the hidden costs can be identified and made visible.
Hidden costs differ in terms of their cost application. However, it is possible to differentiate between two types of costs: direct and indirect.
Direct costs are characterized by their ability to be specified via budgets. These are directly attributed to specific goods or services. For example, in case of an IT investment, the direct costs are:
- Purchasing costs of hardware or the necessary software (leasing costs, depreciation, etc.)
- Costs resulting from maintenance and service contracts
- Costs for administration and support (operational costs)
- Training programs for staff and end users
- Consumables and facilities (e.g. environment-controlled server room)
In simple terms, indirect costs means expenses not directly linked to an investment. These are caused by unproductive usage or poor procedure—eventually leading to lost productivity, with negative implications for competitiveness and economic efficiency. The fact that such less-productive processes are often not easy to measure and to identify certainly does not ease things.
Nevertheless, indirect costs have a big impact on keeping systems running and functioning well. To give some examples, indirect costs attributed to software investments could have their cost source in one of the following:
- Server or software downtime: not an unknown occurrence, it usually hits broad user groups and leads to relatively high losses in productivity; the staff cannot perform its work.
- Improvable functionalities and user experience: cost cuts in training programs, slow processing speed of software and/or dedicated hardware, outdated applications.
- “Futz and fiddle factor”: too much waste of working time by users (installing extra software, changing the look and feel of software applications, and so on) as well as usage of hardware and software systems for non-business purposes (e.g. surfing the web, playing online casual games).
- User-driven insufficiencies: users changing configurations, installing viruses unconsciously or deleting important data files and file directories are a living threat to every system.
Admittedly, quantifying indirect costs can be a little time-consuming. However, in the end, this should give you some reward: You may encounter interesting as well as surprising details and results for both your cost control and investment decision process.
To identify both regular and one-time costs, you need to scan the acquisition’s whole-life costs depending on its anticipated average life.
Types of whole-life costs: Three stages of economic lifetime
Exemplary TCO calculation: Purchasing new reporting software
In the following example, a company needs to implement new reporting software because the one currently used is outdated. There are two quotes, A and B, both combined with specific software servicing for a contract period of about 48 months.
The initial costs of Software B are cheaper than those of Software A. However, the annual operating expenses of Software A are much lower. Over the lifetime (period under review: four years), Software A’s total cost of ownership can be rated as being significantly more competitive.
About this blog
Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.