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PurchasingB2B

Total Cost of Ownership

Purchasing vehicles demonstrates the challenges of forecasting TCO and can help develop templates for this type of decision-making


June 17, 2014
by Larry Berglund

It’s easier to estimate out-of-pocket, short-term costs associated with a purchase rather than the long-term ownership costs. We can estimate the costs intuitively over a one- or two-year period with reasonable accuracy to make a decision. Getting past a two-year period invites more variables such as the probability or frequency of the maintenance and repairs or technology advances which makes the current models redundant. Smart phones are a good example of the latter.

We can be biased in making estimates of future ownership costs and benefits. We may want to rationalize the purchase and are selective with the dollar values we analyze so we’re more comfortable with our decision. Or we may want to skew the dollar values so we don’t make the decision.

This is why in business we often use agents to represent our interests and make recommendations on our behalf. We use consultants, legal advice or financial advisors to assist in our decisions. Organizations use a board of directors or elected officials to vet ideas through where strategic or controversial investments are being considered.

If we’re responsible for only a limited aspect of a purchase this will affect our decision. We behave the way we’re rewarded. You may be responsible for the operating budget in your organization. You choose equipment that meets your budget limit. Your budget is met and your department’s operating costs meet your productivity targets. However, the payback is less than desirable from an organizational perspective.

We can make decisions based on altruistic values as opposed to economic interests. We choose to buy an electric vehicle for our commute which costs more to own than a used or conventional vehicle. However, the lower emissions and being an eco-responsible consumer appeals to our values.

Larger projects like the Canadian oil sands operations and the pipeline distribution systems are difficult to forecast for economic, social, and environmental costs and benefits over decades. There will never be a perfect solution.

We argue over the anthropogenic contributions to the greenhouse gas emission problems all the while consuming natural resources to sustain our lifestyle. It’s the rate at which the biosphere can absorb the emissions that adds to the complexity of our options.

In terms of total cost of ownership (TCO), it’s difficult to accurately calculate or forecast the costs and benefits that realize the best solution. Compromises must be made to take action. For example, healthcare programs cost employers more in the goods and services they sell. Again, as a society we accept the additional internalized costs. We’re seeing a shift towards a total cost of ownership model in business and in the public sector. TCO requires input from a broader set of constituents or cost drivers. Assessing social economic benefits of local or indigenous products versus the views of international trade interests is challenging.

We’ll look at vehicle purchasing to demonstrate the challenges of forecasting TCO and assist us develop templates for this type of decision-making.

First, a traditional view of the vehicle purchase decision based on the following data:

Vehicle A is a conventional gasoline-powered vehicle costs $18,800 and the estimated fuel, maintenance and repair cost over five-years is estimated at $.176 per mile.

Vehicle B is a hybrid electric vehicle which costs $24,000 to purchase and the estimated fuel, maintenance and repair cost over is-years is estimated at $.129 per mile.

Based on this, which vehicle should your company purchase? We need to compare the optional cost structure of the two vehicles. At which point does it make economic sense to reduce the operating costs and reduced emissions associated with vehicle B to offset the lower purchase price with higher operating and emission costs associated with vehicle A?

We can calculate this as follows: (Vehicle A) $18,800 + $.176X = (Vehicle B) $24,000 + $.129X (X = 109,890 miles). At 109,890 miles the two vehicles have the same TCO.

An important part of the cost structure is the difference in the purchase price and fixed costs. Whether you insure a hybrid or a conventional vehicle, the cost of the insurance remains the same per year, whereas fuel, repairs, and maintenance are variable costs and change with the mileage. Depreciation correlates to the purchase price as are fees, taxes, and opportunity costs, which are fixed over the vehicle’s life. If the organization estimated the vehicle usage at only 50,000 miles over five years, purchasing would recommend vehicle A as the lowest cost solution.

The rationale is that if you’re driving less than 109,890 miles over vive years, you’re better off purchasing vehicle A. Conversely, vehicle B makes sense if you expect to drive more than 109,890 miles over five-years. This makes the TCO calculation a challenge. What might change to affect that volume of travel?

What about the cost of emissions associated with the two vehicles? The EPA estimates that a gallon of gasoline emits 20 pounds of CO2 when driving. Even hybrids will burn gasoline in urban settings.

If vehicle A emitted ~24 tonnes of CO2 over the five years it could be offset at a cost of the prevailing rate of $22.00 per ton or ~$600 through carbon credits—a nominal charge. Where carbon tax is collected at the pump, in B.C. for example, the offset of emissions is already included in the price of the gasoline for all vehicles. The hybrid would emit far less emissions but would still emit in the range of five-to-10 tons over the same period for a cost of $100-200.

When looking at the more inclusive total cost of ownership model between these choices we get a slightly different picture. The TCO between the two models indicates a saving of $1,035 over five years in favour of the conventional gas powered vehicle. The $1,035 difference wouldn’t likely influence the initial purchase decision as much as the value-based decision to purchase a vehicle where there’s an affinity for vehicles that protect the biosphere and resonates with stakeholders.

If an organization wants to demonstrate corporate social responsibility, the hybrid makes sense. From a business perspective the hybrid also has a reasonably sound case.

A part of the complexity is the unknown future travel needs, cost of fuel, legislated emission levels, vehicle designs, and market values for used vehicles. Even in the absence of other information, we may make the decision on the hybrid based on corporate principles. Going with the hybrid isn’t solely a purchasing decision. It’s also a corporate one, with alignment between values, image and brand.

Drawing from Buying Local: Tools for Forward-Thinking Institutions author Tony Pringle makes a good argument for supporting locally produced goods and services. When we consider the economic multiplier effect, many public institutions (paid for by taxpayers) are in a position to provide improved social benefits and affect economic development strategies. The economic multiplier is based on the premise that goods and services purchased from locally owned businesses—often SMEs—recirculate revenues within the local economy more than MNCs. In turn, local revenues continue to be spent locally. Without an awareness of the economic multiplier effect, decisions may not be factoring the TCO associated with spending. This doesn’t mean local sourcing should favour sole sourcing—TCO reiterates that the lowest cost may not realize the best community value.

Most business decisions are based on strong economic assessments. The TCO model assesses total direct and indirect costs objectively. The economic benefits may outweigh other business value factors.

Larry Berglund, SCMP, MBA is Principal, Presentations Plus Training & Consulting Inc. His supply chain experience includes leadership positions in the forest industry, public health care, municipal government, university operations, academia, and consulting services. He teaches supply management and corporate social responsibility courses, webinars, workshops and has published many articles on these subjects. He facilitates online training for UBC and NECI and is currently writing his new book, Good Planets are Hard to Buy!