The importance of Total Cost of Ownership

The importance of Total Cost of Ownership

"I'm in for a big promotion!" exclaimed Bob, seasoned commodity manager for an American ball bearing manufacturer. "I found a new low-cost supplier in Malaysia that cut my unit costs by over $7 million annually. Based on this 35 percent unit-cost savings, the Purchase Price Variance component in my next review will be off the charts!"

"Way to go, Bob," said Hank, Bob's long-time co-worker.

"The steel we use to make ball bearings amounts to half of our annual material expenditures. To make sure these savings were guaranteed, I asked our local trucker to check with his freight forwarder friend on the Safeguard Steel Tariffs President Bush put in place, and he confirmed that our steel was exempt. So life is good! For the first time in my career, the CEO personally thanked me for my work."

Unfortunately, Bob's assumptions were wrong. He actually increased his company's total costs by over $4 million annually. Increased transportation costs, a Safeguard Steel Tariff of 24 percent (oops, unqualified advice from the trucker), and greater inventory-carrying costs collectively exceeded his projected 35 percent savings in material costs.

Disturbingly, this scenario is all too typical of the way many large companies make global sourcing decisions. If the financial success of an international transaction is based on reducing unit costs alone, commodity managers will inevitably make material selections that reflect that objective, thinking they are reducing costs by 30 to 50 percent when they are inadvertently draining profits from the bottom line.

The increased emphasis on low-cost sourcing appears unlikely to decline anytime soon. Then why are so many companies still struggling to realize proportionate increases to their bottom line?

The reason is that the projected savings do not accurately model the Total Cost of Ownership (TCO). When measuring total landed costs for material purchased internationally, this number must encompass everything from the material itself and its transportation costs to all affiliated duties, tariffs, taxes, insurance, inventory carrying and risk-management costs.

The Aberdeen Group, in its July 2003 Global Trade Management Benchmark Report, estimates that when these costs are included, total non-material costs account for 20 percent to 40 percent of a product's total cost.

The fluctuating non-material expenses of international trade aren't going anywhere, and neither is a growing dependence on an ever-shifting pool of low-cost manufacturing countries - despite worldwide security concerns. The new velocity of global events simply adds to the list of factors that affect the supply chain and the cost of purchased goods. Companies must consider constantly changing tariffs, as well as the added cost of delays due to new security measures and the cost of creating accurate, timely documentation when reviewing their TCO.

The critical success factor to managing today's global supply chain is realistic cost modeling that can be as dynamic as the cost factors.

You need to know the manufacturing country; the ship-from country; the destination city, state-province and country; the manufacturer's name; the product classification for that import country; the product's value for customs purposes; the consignee; the net and gross weight of the product; the ship date and estimated customs clearance date; transport mode; transport charges; and any conditional qualifications (which vary by country).

Put all of these into an equation, multiply by the applicable duties, taxes and other import fees, and you have now identified your landed cost. But what about the other cost of ownership-proprietary pieces such as inventory-carrying costs, safety stock, quality costs, vendor management expenses and local taxes or credits? These factors play an important part of any TCO calculation. For example, ocean freight equals longer transit time and more inventory-carrying costs, while airfreight reduces transit time and inventory costs but increases transportation costs.

Now you've simplified the equation to read: Landed cost + Ownership costs = TCO.

To be successful, you must be able to quickly calculate your TCO drawing from live data that will alert you when any of the base scenario components have changed. When you are able to conduct "what if" scenarios, you can quickly weigh the effects of change on any element of your total cost and transit time to optimize global sourcing and deliver immediate, positive, bottom-line results for your company.

Frank Cirimele is vice president, global trade at Xporta Inc., a global trade consulting firm. He can be reached at (408) 556-1446, or via e-mail at fcirimele@xporta.com.