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back to index backLATINtalk May,  2005

Beyond Total Cost of Ownership (TCO)

Where do you see small and medium sized businesses (SMBs) falling short of sourcing decisions based on total cost of ownership?

Small and medium sized organizations tend to lack the discipline to understand the full spectrum of costs going into any kind of sourcing decision. It's easy to look at the one-time acquisition costs. But it's difficult for them to look at many of the recurring costs.

For example, a small manufacturer might be equipped to identify the cost centers and departments that will be impacted by a purchasing decision but they will typically fail to analyze and understand the ongoing operating support required for the majority of investments. With any new supplier, there is an element of risk because you don't know what you don't know.

Typically, a SMB will conduct due diligence including a supplier visit to identify potential issues when significant dollars are involved. Some of these issues get resolved during this qualification visit, but many will not. It is rare that SMBs really understand how to satisfactorily resolve all key issues and they often get pushed aside because something else takes higher priority. This often becomes a silent” risk due to lack of follow-through. And that is just focusing on the issue that they were able to identify. The issues that they weren't may present even greater risk.

In the rush for companies to source globally, what are the three most significant elements that tend to get overlooked?

One element that often is overlooked is the whole notion of risk. A supplier might have been terribly aggressive on price but there might be additional risks associated with sourcing from the lowest priced supplier.

This risk leads to the next element that is often overlooked—supplier stability. SMBs must decide how best to analyze their supplier's financial health during the participation by suppliers in a bidding process. Is this supplier likely to make it or not make it? Are there any predictors of risk (e.g., credit rating) that we can examine to gain a better understanding of risk? What is the supplier's competitive position? What will the supplier's owners do if their business is fatally compromised? Sell? If so to whom, and what are the acquirer's motives? Requests for Information often are a part of the picture, yet the survivors are expected to not compromise performance such as on-time delivery.

A third area that is typically overlooked revolves around product innovation. Is the supplier innovative? Have I picked a company that is going to bring new ideas, materials etc. to me or am I having just a supermarket type of transaction with them? How can I tell if over time, I am really in a value-based relationship vs. a series of low price transactions?

What is beyond total cost of ownership?
What are companies not looking at?

I see several areas beyond total cost of ownership that all SMBs should be looking at: One area would be to better understand all of the benefit streams from switching suppliers—particularly around product innovation and quality (and the revenue associated with that). For example, if by switching suppliers, a SMB frees up 240 hours of QA man hour time…how does that get factored as a benefit? Another benefit occurs downstream. It's really a deferred benefit and that is when you pick the right supplier, you don't have to keep picking” the right supplier. I've also seen that new suppliers tend to be hungrier for business—they will actually work harder to achieve the benefits, and please the company.

I've mentioned the notion of risk” earlier. When sourcing from China, for example, do companies understand the market dynamics and the geopolitical risks (e.g. increase in oil and freight costs) involved? How will the burgeoning middle class in China—and hence the insatiable demand for construction oriented materials including steel—impact an SMB's ability to effectively source from China long term? There is no easy way to quantify these risks. If you buy a stock, you'll look at the risks of the company. Every line item about that company can be assigned a cost and a benefit. It's easier to create a column to cover all of the risks and assign weights to the items. TCO does not offer this type of risk weighting.

Of those elements, how do you begin to quantify the value of these?

One method might be to begin taking into account the number of man-hours it takes to execute the sourcing decision. If you pick the right partner, you have avoided at least some part of that cost if not all of it, and hence you have incurred a benefit.

Theory of Constraints and Throughput Accounting offers another lens through which to view benefits. If a supplier uses TOC (Theory of Constraints) and uses Throughput Accounting it's possible that the supplier is using a more sophisticated costing, pricing and bidding approach than the buying company can handle. These suppliers may also be much more competitive than others when the market, and not capacity, is their constraint.

Often, the strength of total cost of ownership models can end after a sourcing decision is made. And all too often recurring costs and other value-added costs are not quantified.

Alistair Stewart is Senior Business Advisor of The Chicago Manufacturing Center.

Source: Aptium Global GunPowder” Newsletter - GAI

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