How to use total cost of ownership to drive a cost containment strategy.
April 28, 2017
by By Vince Amanyi
Cost management has been shown to be vital to value creation and will help to generate revenue if implemented effectively. Total cost of ownership (TOC) is one of the best drivers to deliver cost containment that will be visible within an organization’s enterprise platform. Every product or material has a lifecycle cost implication to the organization’s direct expenditure, which sometimes translates to opportunity cost based on your organization’s maturity within your industry. Understanding lifecycle cost helps purchasing professionals and organizational leaders apply all the variable cost drivers into planning from the front end, as this will streamline the value chain and translate to dollar value.
A cost containment strategy is not a silo concept that is dependent on a single business functional area—it requires clearly defined inputs from multiple stakeholders that have a role in procurement. This can range from design team, estimators, engineers and others as all stakeholders will provide valuable input on various material properties. The ability of stakeholders to identify value chain, which is direct cost reduction initiatives, as this involves all stakeholders within the enterprise to adopt smart ways of executing their responsibilities. An example could be enabling collaboration among team members in the supply chain department with other departments that share day-to-day transactional information.
A best-in-class cost management approach requires effective leadership that will galvanize the entire range of initiatives in a disciplined manner, thereby capturing information that will support a good decision-making strategy. There are several elements in play when deciding what should drive your final deliverables. A manufacturing firm will need to segment the entire variable and fix cost, as well as map out the plan schedule for the lifecycle cost of all the materials within the bill of material (BOM) that make up the complete material. This will create a leverage to predict carrying costs of the material or product in the case of an asset like a car or machinery. The individual cost and the properties of the material that make up the bill of material can be used to project the total life cycle cost of the final deliverables. Organizations that have a maturity model in their enterprise procurement spend analytics have the tools to manage their costs on all capital expenditures (CAPEX).
The science of total cost of ownership starts with defining an objective, since the product’s usage changes the projected cost of ownership. The application of TOC theory will help organizations do detailed planning from the front end, which will support the organizational decision support system regarding the cost reduction program initiatives. Total cost of ownership is also the art of using your organizational budget to establish the best path to create and align excellent cost saving programs on an enterprise scale, which is currently happening in some disruptive innovative firms.
The front-end planning of strategic procurement is vital to developing a foundation of TOC, because lack of this framework will only project a fluid cost program which will be overridden by future cost build ups throughout the product’s lifecycle before decommission or disposal. Cost containment is not a onetime event. It’s a program that requires a disciplined approach from all functional organizational leaders within the enterprise platform. The need for excellent category management is critical to classifying all material/product purchases based on spend analysis, because the segmentation will give management a snapshot of annual or bi-annual spend, presenting them with the opportunity to monitor their budget real time.
The increased need for cost savings is putting pressure on procurement leaders to devise tools that will create the enabling environment to design effective strategic sourcing initiatives that translate to a more agile collaborative platform among internal stakeholders, and research new entrants into the supply base. The strategy of competitive advantage in re-tooling your TOC will further reduce the overall cost of the finished product by establishing a definite baseline, which is fair market pro-rated cost.
Total cost of ownership can be defined as the overall cost of a product from acquisition to disposal or decommission, and the cost span through a long time. The cost of any capital project procurement should be locked down by aligning to an expanded warranty as part of the original cost, and a reduced negotiated rate on all support services that could result from the execution of contract enterprise-wide with agreed predefined milestone.