Many businesses use some form of Total Cost of Ownership model to support their Procurement and sourcing decisions. In fact these models are not just used casually, but they often are designed to inform and make optimal sourcing choices.
But many dynamics that we have experienced in the last few years suggest that these models are less than optimal. From chronic global Supply Chain breakdowns during the pandemic through to disruptions caused by outsourcing and single points of failure, sourcing decisions have been exposed as being less than ideal.
What is the current nature of these Total Cost of Ownership models, and what needs to change to make their use more robust and responsive?
What is a Total Cost of Ownership Model?
In my experience Total Cost of Ownership (TCO or TCOO) models typically include some combination of the following elements:
- Unit price (Always the first item)
- Takedown rate performance
- Payment terms
- Freight and Logistics terms and transfer of ownership
- Lead times (order, delivery, replenishment)
- Other Parameters (eg. MOQ, Safety Stock)
- Performance (quality, delivery, responsiveness)
- Inventory positioning (eg. Supplier Managed Inventory (SMI) hubs)
- Innovation activities
- Ongoing maintenance costs
- Technological capabilities and differentiation
- End of life product support and excess and obsolete inventory management
- Corporate Social Responsibility
- Environmental and Regulatory standards compliance
- Electronic and systems connectivity
- Cost of employee relocation (eg. ex-pats)
- Financial stability and viability
The Total Cost of Ownership includes some number of these various factors. But price is ALWAYS included. Given that all of these factors are not measurable in dollars some alternate scoring mechanism is used. For instance, Corporate Social Responsibility might me measured on a scale of 1-10, 1 being poor and 10 being best in class.
The normalization of these various factors will result in some “score” for each factor which, when totalled, will give a summary score allowing for the ranking of suppliers for the purpose of comparison.
The value of each factor may also be weighted to reflect the relative importance of one factor vs another. For instance, unit price may get a weighting of 40% of the total score whereas Environmental compliance may get a weighting of 5%. The total weighting will be 100%.
Typically and historically sourcing decisions were predominantly based on unit price. Over time, some enlightened people determined that this approach was limited and shortsighted given all of the other dynamics involved in sourcing and supplier management.
The concept of using Total Cost of Ownership models to inform Procurement sourcing decisions is to take all of these different factors in to account, beyond just price. While price is important many of these other considerations, even if not quantifiable in dollar terms, do influence the time, cost and energy involved in dealing with one supplier versus another.
The TCO models are intended to provide a longer term and more strategic view to sourcing decisions, beyond just thinking about where to place the next purchase order. They are meant to capture the total acquisition cost of goods and services over an extended period.
That’s the concept, anyways!
Where do these TCO Models break down?
If the operating environment for a company, and its extended Supply Chain, was static and completely impervious to change or disruption, then adherence to the recommendations and principles derived from a Total Cost of Ownership model will lead to good sourcing decisions.
But the reality is much different. There are internal forces and external forces which destabilize Supply Chains, rendering these TCO sourcing decisions faulty at a minimum, and fatal at its worst.
One of the primary flaws with these models starts with adherence and compliance.
Let’s consider pricing for instance. When profit pressures intensify, when competitive pressures on pricing grow, and when organizational costs are rising, the Procurement organization will be pressured to make sourcing decisions solely on price.
CEOs and CFOs will pressure Procurement to negotiate lower prices and to award business to the lowest cost suppliers, regardless of all of the other facets of their TCO models.
The outsourcing of manufacturing to low cost geographies is an example of the extreme manifestation of ignoring most other TCO factors other than price. For decades now companies and industries have been moving work to other continents, or to developing parts of their continents, so as to capture the lowest possible cost.
However outsourcing to low cost geographies result in incurring many other costs, which are not as visible as unit price. Managing suppliers across oceans requires investments in resources, infrastructure, systems, processes, audits, and travel.
Most concerning is that these outsourcing decisions very often create single sourcing, or sole sourcing, scenarios. Even if you could move the business to other suppliers you are still captive to having all of your manufacturing eggs in one country’s basket.
And when the global Coronavirus pandemic hit, disrupting every Supply Chain in every industry, no country was immune.
All of this creates what we call “Single Points of Failure”.
Think about semiconductor fabrication for instance. With the majority of semiconductor fabrication occurring in Taiwan most countries have lost the expertise, talent and resources to repatriate this work in the short term. Given semiconductor supply disruptions occurring throughout and after the pandemic, most countries and companies have no meaningful fabrication alternative.
Another example involves the baby formula shortage. Over time production of key elements of this product were centralized in a single production facility in the United States. A singular focus on cost created this single point of failure. And what happened? The baby formula Supply Chain failed.
When a container ship became stuck in the Suez Canal and blocked movement of goods serving entire continents a single point of failure was exposed. Companies were not prepared for this eventuality and most had no alternative logistics option or solution.
More often than not a singular focus on sourcing based on price, will result in a single or sole sourcing decision, which has enormous risk of exposed continuity of supply, and this is not factored into TCO modelling.
Another area where TCO models fail is due to the integrity of the scoring. Some factors are very objective and are numerically calculated. Other factors are more subjective in nature. And very often those subjective factors make Procurement management and others feel good, but they are often given a very low weighting or ignored altogether when price is a factor.
These TCO models very often do not consider risk management. They assume environmental stability. Scenario simulation to observe the impact of sourcing decisions when Supply Chains are disrupted is missing.
As such when disruptions and disasters do occur in real life there has been no contingency planning to allow for the rapid activation of alternative sourcing solutions. This is a chronic and fundamental flaw in TCO modelling.
TCO models are most often designed to spit out one answer, to recommend one supplier to which business is awarded. There is limited effort, unless there is human intervention, to award business to multiple sources, thereby reducing risk to continuity of supply and creating a more robust sourcing solution.
As stated earlier, this usually occurs because of the overriding and singular focus on realizing the lowest possible unit price for goods and services.
How should these Models be changed for the future?
Disruptions occur in Supply Chain all of the time. Whether they are localized to an operation, a company, a geography or an industry they will occur. Whether they are global in nature they will occur. Whether the are man-made or natural disasters, they will occur.
Total Cost of Ownership modelling with no consideration for these inevitable disruptions and the need to de-risk Supply Chains is reckless. Nothing runs smoothly each and every day. To ignore that reality in making sourcing decisions is to invite havoc that in its extreme can cause any company to fail.
The predominant focus on unit price is extremely hard to overcome. Its overarching importance will not likely be mitigated. But a focus on creating equally competitive, dual sourcing or multi-sourcing solutions can create a more robust and resilient Supply Chain. While this will not prevent problems, it does establish a basic sourcing solution that can better withstand any disruptions.
Finally we need Procurement to play a stronger role at the executive level. Too often Procurement is not viewed as being strategic despite the fact that it usually manages the majority of the costs of many companies and industries. If Procurement has a stronger presence in the Boardroom it can educate and inform their peers so as to alleviate pressures to make sourcing decision solely based on price.
A danger that we are concerned about is that after the pandemic companies will go back to their old ways of doing things. For all of their flaws and shortcoming, Procurement team will continue to use, or not use, their Total Cost of Ownership models as they have always done.
Everyone will forget how the pandemic brought every company in every industry in every country to their knees. Concerns about on-shoring vs offshoring will be forgotten. And companies will continue to source primarily to the lowest unit cost supplier, ignoring all other TCO factors.
Enlightened Procurement leaders and teams will see the value and opportunity to create more robust and resilient Supply Chains through better sourcing decisions recommended by strengthened TCO models.
Everyone else who ignores this need to change are just kidding themselves. They are putting their employees and their companies at risk of failure.