Devising and adopting systematic ways of measuring costs accurately

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Strategic supply chain management is primarily concerned with striking a profitable, sustainable and effective balance in a company's relationship with its customers, suppliers and competition (Hines 2004). According to Lysons and Farrington (2006), purchasing represents a large portion of the costs incurred by firms and thus, savings realised from optimised purchasing practices and calculated supplier choices may likewise contribute towards increased profit margins. The challenge therefore, is for buyers to device and adopt systematic ways of measuring costs accurately, especially when different components of a product are purchased from several suppliers (Woodside, Golfetto and Gibbert 2008).

Most traditional cost models, some of which include empirical judgement, elemental analysis, weight point analysis and matrix approaches, (skitmore and Marston 1999) inferred in their application, that all costs may materialise as cash and can be quantified as such, but this has been shown to be incorrect in some instances. The assumption under these models is that the choice to select or retain a given supplier is a function of the price they are willing to offer for a product compared to the prices offered by competing suppliers (Hines 2004). Cousins et al (2008) demonstrates that the method proposed by older models is not as empirical in practice as was assumed because some costs are measured in non-cash terms. These costs may include savings that free up a firms capacity to invest otherwise, or costs that materialise in other forms that are not necessarily monetary or immediate (Cousins et al 2008).

Therefore, to consider the cost implication of a company's purchasing strategy in terms of how much it is able to save against a target forecast; usually a previous purchase price (Cousins et al 2008) may be misleading. Lysons and Farrington (2006) stated that savings realised from a leveraged purchase practice may impact directly on a Firms profit margin, only after other factors such as product defects, reverse logistic costs and other costs not directly incurred with the actual purchase have been considered. This implies a clear distinction between a theoretical cost savings and the actual cost savings from a purchase (Van Weele 2010).

Of the several life cycle costing models, the total cost of ownership (TCO) technique has been used extensively in industries to categorically define the cost functions of purchasing beyond purchase prices alone (Emmett and Crocker 2006). The premise of the TCO model is that the benefit of ownership of any asset is material to the buyer only when the value added by purchasing the asset is greater than the cost of owning it (Emmett and Crocker 2006) .This is not to say that the TCO model's advancement over other empirical predecessors makes it essentially universal and absolute in application (Hines 2004) as several other models are applied in the estimation of the cost function of purchasing in various firms (Aravossis et al 2006). Zachariassen and Aribjorn (2011) pp.449 citing Wouters et al (2005) and Ellram and Siferd (1998) stated:

"A study regarding the use of TCO among Dutch firms revealed that many purchasing managers have little experience in applying TCO and value analyses. The reason for this could be found in the fact that some managers fail to see the purchasing function as a strategic resource."

This paper comparatively examines the merits of the TCO model over linear weighing models like the Activity based costing (ABC) model; mathematical programming models like the Direct product profitability model (DPP), which is usually employed at the retail end of the supply chain to tackle costs associated with warehousing and sales (Bastl et al 2010) and the Cost-to-Serve method (CS) which captures external SC costs of logistics and identifies external cost drivers along the value chain (Bastl et al 2010). Emphasis will be made on the current challenges posed by adopting the TCO model and possible solutions.

The major selling point of the total cost of ownership (TCO) model is that while costing and purchase decision making models like the linear weighing model, which ascribes weights based on level of importance of several criteria considered like acquisition and maintenance costs, supplier lead time and quality in its selection process (Aravossis et al 2006), the TCO model incorporates all relevant activities that generate cost as the product moves through the value chain (Cousins et al 2008). This means that costs associated with the acquisition, future costs of maintenance, repairs and installation and the opportunity cost trade-offs between investing in a given purchase at a specified time and the interest payable if funds were invested otherwise is covered by the TCO model (Emmett Sodd 2010). The Activity based model(ABC) for instance takes into account all the cost driving activities associated with a purchase but is hardly useful in identifying value adding and non-value adding activities in the process (Bastl et al 2010). However, the overemphasis on saving investment costs implied by the TCO model, plays down the consideration of overall business value in supplier selection and has led some companies to implement TCO evaluations as a substitute for proper business value analysis and investment prioritisation decisions (keen 2004). Keen (2004) stressed that TCO is only a part of the entire value consideration in a business investment and must be adopted alongside system efficiency and effectiveness, as well as business efficiency determining procedures.

The mathematical multi-objective programming costing models depend on a system of collating historical business statistics data on purchase decisions for vendor selection by assigning weights to each criteria and optimizing choices, starting with the most important objective (Chandra and Grabis 2007). Apart from minimum costs, these models also consider vendor selections that maximise profits based on stochastic evaluations. They apply regression analysis to quantify the return on investment (ROI) associated with each supplier choice and identify the impact of an investment on a business not only in terms of the cost saved, but also in terms of the profitability of the selection (Kaplan 1998).

Lower costs and higher profitability impact the bottom line in much the same manner and vice-versa (Simchi-Levi, Kaminsky and Simchi-Levi 2008). The Cost to serve model (CS) for instance, assumes that customers should be managed for profits and not just sales and revenue alone (Bastl et al 2010). In this regard, the TCO model holds merit over most costing models in its application to several concepts in the analytical process. (Hines 2004). It considers divers parameters from several fields of management like the net present value (NPV) of a purchase, the product pricing strategy, reliability and quality measures, consumer measures, fleet and logistic choices and economies of scale and scope in supplier selection (Hines 2004). Furthermore, recent supply chain trends emphases lowering of product profit margins because of growing competition and constant research into better production techniques. This lends credence to costing models like TCO that border around reducing the fixed and variable costs associated with procurement and manufacturing, considering a cost saved to be just as good an advantage as a comparatively higher profit margin than competitors (Chopra and Meindl 2007).

While the TCO approach is robust in context, it is still difficult to establish to what degree the adoption of a TCO model directly adds value to sales, increases market shares or provides a clear competitive advantage (Kaplan 2005). Decisions that are considered optimal from the total cost perspective may not be appropriate in terms of the company's total revenue (Skjott-Larsen and Jespersen 2005). In spite of its scope, TCO in isolation from other purchasing decision criteria does not consider intangible costs and thus, it is difficult to establish to what extent decision makers may allocate cost functions to various assets (Keen 2004). Also, there may also be cost and time implications associated with adopting the TCO model itself since most overhead procurement decisions are time sensitive and the TCO process may require a lot of time for its extensive analysis (Keen 2004). On-going and transition costs that may arise as a result of a decision to discontinue the use of a supplier for another are also not considered in detail by the TCO model (Skjott-Larsen and Jespersen 2005).

In order to be sustainable as going concerns and profitable, supply chains must evolve from a system where suppliers and buyers optimise their profitability in isolation, to a stage of global optimisation where the entire chain is considered in terms of cost savings and profitability (Simchi-Levi, Kaminsky and simchi-Levi 2008). TCO analysis is thought to help suppliers improve their products and profitability by reducing the additional hidden costs and improving the supply chain capability as a whole (Lysons and Farrington 2006).

A study that looked at TCO in supplier selection from an inter-organisational perspective however showed that a differentiated approach to TCO in supplier selection should be adopted instead of viewing it solely from the buyer's perspective, as some suppliers react negatively when TCO is considered to be used as basis for negotiation to beat down prices (Zachariassen and Aribjorn 2011). Below is a table illustrating the different supplier reactions to the TCO approach, based on how each supplier's relationship with the buyers determines if TCO is perceived as mutually beneficial or merely a negotiation criterion to favour buyers alone.

TABLE 1.0 How TCO affects relationships between buyers and suppliers (Zachariassen and Aribjorn 2011)


Supplier number



Trust and commitment


Supplier 1

Increased amount of

communication between

buyer and supplier as

the introduction of TCO

leads to extensive


Risk increased, as

uncertainty increased

due to the buyer and

supplier having

difficulties in reaching a

common understanding

Experienced trust issues,

as the supplier was put

off by having to discuss

unnecessary TCO data


Supplier 2


between the two parties

became distorted as the

use of TCO data resulted

in prolonged and



Uncertainty rising

between the two parties,

as the use of TCO data

by purchasers was

perceived negatively by

the supplier, causing an

increased risk for parties

not reaching an


Trust on a low level,

as the buyer tried to

manipulate the supplier

by the use of TCO data


Supplier 3

Created improved

communication when


Risk decreased due to

improved cost data, as

both parties were able to

agree on the costs that

were a part of the


Both parties experienced

increased commitment

and trust due to

improved decision

making in relationship situations


Supplier 4

Learning environment.

Both parties experienced

an increased ability to

learn from each other by

communicating better

Risk decreased, as both

parties were able to

identify those cost

categories that could

create potential

problems later on in the


Trust and commitment

increased, as parties

were able to align their

goals and incentives due

to the improved cost


From the above case study, Zachariassen and Aribjorn (2011) established that the different reactions from the suppliers sampled was as a result of different levels of relationship with the buyers, which must be considered in the adoption of TCO analysis for decision making. It was proposed that different TCO approaches should be used, in some cases at advisory levels, depending on the level of supplier-buyer relationship that exists. This is particularly important when decisions have to be made about critical components to be purchased, the purchasing terms and the length of purchasing contracts (Lysons and Farrington 2006).

Global competition, cheaper labour and advancements in technology have made product life cycles even shorter; as short as 6 months to 3 years for consumer goods, after which assembly lines may be changed due to new technologies or innovative advancements in the product design (Heilala Montonen and Helin 2007). To address this issue in manufacturing, TCO has been successfully used with other models like cost of ownership (COO) and component-based simulation technologies (that simulate the components of each facility as obtained from different suppliers), to model scenarios of cost, time and quality and to determine the best trade-off of these variables in the selection and adoption of optimised assembly lines (Heilala Montonen and Helin 2007).

It has been argued however, that although TCO models are most practical in supplier selection decisions, the model has no provision for decision makers to plan for interventions that will mitigate against the risk associated with any given supplier selection, since supplier behaviours are not sufficiently predictable (Micheli 2008). Bhutta and Huq (2002) pointed out that the TCO model does not provide enough information in its analysis for it to be used in isolation as a decision making criterion, since no information is provided by the model about the risk of selecting a given supplier. According to Matos (2007) as cited by Micheli (2008), TCO should include an analysis of the worst cost scenario possible in the event that the worst supplier is selected based on TCO results.

However, since the total cost of ownership model provides the most up-to-date analysis of hidden costs, a supplier selection approach that builds on the TCO model and includes an analysis of the decision maker's potential choices should be developed so that the model proffers interventions in case there is an unforeseen variability arising from a given supplier selection (Micheli 2008).

To conclude, the total cost of ownership analysis holds merit over most costing models and is most applicable for buyer's decision making processes because it provides an extensive account of lifetime costs which may not be obvious until after a purchase has been made. It should be used alongside other holistic criteria; for instance, a company's corporate strategy may include a decision to select only suppliers whose processes are environment friendly. Such a criterion may be intangible to consider and cannot be measured to any extent using the TCO model in isolation because the favourable supplier in this instance may not be the most cost effective.

Also, buyers should consider their relationship with suppliers in negotiations based on total cost of ownership. The emphasis should be on improving the supplier's capacity to reduce hidden costs otherwise unconsidered, to ensure global optimisation of the supply chain as a whole, rather than each echelon of buyers and sellers attempting to optimise profits and manage risks locally by using the TCO technique as a strategy to negotiate good buy bargains.