Total cost of ownership: The challenge of effective supply chain management
Friday, April 17, 2015
Companies are always looking for creative ways to reduce costs and expand profit margins. In some cases, new and innovative approaches are employed. In others, proven but overlooked techniques are being resurrected and applied.
The impact of total cost of ownership upon cost reduction and profit elevation among capital-intensive industries is quite significant, yet this approach has been largely missed. Many industries, particularly within the oil and gas production sector, would benefit greatly from the adoption of this concept.
Typically, capital cost considerations are dealt with at the time of sourcing — primarily involving the purchasing organization blended with other organizations such as engineering or IT. What is considered at that time is primarily the "obvious costs," such as purchase price and maintenance/service agreements. The thought process usually stops at this point.
What is generally missed, entirely, are the so-called hidden and "life cycle" costs, which are quite significant. These include items such as acquisition, upgrade over the life of the item, configuration, setup and deployment, transport, site preparation and installation, operating, management (such as training and user orientation), infrastructure support, insurance, environmental, depreciation, disposal, etc.
Over the equipment's lifetime, these costs can meet or even exceed the purchase price of the equipment.
To more fully understand the benefit of adopting this process, one needs to look at just a few of the many successes:
- The Solvay Corporation lowered its cost structure by 30 percent through the application of TCO processes
- Wartsila Corporation has experienced a 65 percent reduction in spare parts costs as well as a 50-55 percent reduction in life-cycle maintenance costs as a result of derivative programs spawned by a major TCO initiative.
Benefits such as this are quite achievable and are within the reach of those enterprises willing to devote a minimum investment of focused time and resources. These benefits can be realized with no organizational disruption. Typically, one can expect significant benefits in the broad P&L areas of CAPEX, OPEX, cash flow, NPV, profit and retained earnings.
In the oil and gas industry, for example, the reason for this lack of effective adoption can be attributed to:
- lack of awareness of the benefits to be realized
- misunderstanding of the concept and its workings, or even a basic knowledge of its existence within the industry, given other priorities
- unfounded perception that it is an intricate and difficult process
- belief that the expertise to accomplish this effort does not reside within the existing enterprise
- confusion as to who would be the appropriate driver/owner of the effort
- perception of it being too much of a departure from normal operations and a potentially disruptive process
- difficulty in measuring or attributing results specifically to the TCO effort
Actually none of these perceived obstacles is valid, and the fact is that the adoption of a simple process utilizing basic tools can yield significant savings over the life cycle of the asset(s). Here are the keys to success
This process doesn't need to be complicated. Although it is possible to adopt complex costing models, purchase exotic software solutions, etc., none of this is necessary. Although these approaches may be precise and appeal to the more academically oriented within the organization, they create additional costs and are not sustainable.
For the TCO process to have impact, it must be understandable, repeatable and capable of becoming part of organizational ritual. An example of a simple cost matrix, as shown below, is an initial tool to conduct meetings, control the TCO process and report progress to senior management.
This cost matrix identifies primary cost drivers, assigns accountability and determines goals. This is a simple, but important tool that forms the basis of all team replaces unnecessarily complex costing models.
Individuals located throughout the enterprise who consume the value of or are impacted by the existence of the particular asset need to be involved in the decision-making process. This organizational teamwork is an unintended, but highly beneficial result of the TCO process.
As subordinate goals are identified, leadership across the organization is naturally drawn together to ensure that each department's outputs are aligned with the overall process objectives. Effectively, the TCO process will elevate procurement to an enterprise-level function from an insular activity of the purchasing department.
TCO helps to solve a long-standing flaw in the procurement of capital equipment by involving those functions/stakeholders who consume the value of the purchased asset or who are in some way affected by its existence. This fact alone almost guarantees the purchase of a more cost-effective and value-producing item. The TCO process must become an integral part of the strategic sourcing process and a key activity of any commodity team.
Measuring results is important to any endeavor such as this. People need to know the impact of their efforts in order to stay motivated and productive. This is a particular problem with TCO programs in that the impact can be dramatic, but the results will be diffused over many different reports and documents.
Aggregating the numbers and attributing them to the activities of the TCO effort is not always obvious. Traditional accounting methods do not accommodate this sort of data retrieval. Activity-based accounting held out the promise of being able to accomplish this but, as we know, it never truly materialized.
Still, it is possible to estimate impact through the application of innovative and preemptive tracking techniques that should be in the arsenal of any accomplished financial analyst. Goal setting should be realistic, measurable and achievable.
Leadership and team composition is vital to the perpetuation of the process. "C" level sponsorship is key, however it is naive to think that a boardroom executive has the time to run or participate in meetings. Their contribution needs to be one of motivation and sanctioning participation and results.
The active leadership role must come from a committed individual, most likely from the purchasing organization or a key functional area such as engineering or IT.
The complexion of the team must reflect the broad spectrum of functions that are involved with the asset during its life cycle and have the knowledge base to contribute at a high level. Depending upon the characteristics and application of the asset, a typical team for example might involve: purchasing, new product development, engineering, operations, finance, R&D, quality, facilities, IT, etc.
TCO meetings should be formal, documented and have a communications protocol. The meetings need not be frequent but must have impact and therefore require significant preplanning by the leadership.
As part of the strategic sourcing process, this approach provides an excellent method for selecting the best equipment and the best supplier to meet the long-term profit and reliability needs of the enterprise.
The process for realizing substantial savings for any capital-intensive enterprise is simple and easily executed, and the potential savings can be dramatic. The reward versus the required effort mandates the serious pursuit of a total cost of ownership process.
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