The importance of TCO in Purchasing
By Emiliano Era, Chief Supply Chain Officer
26 May 2023
The importance of Total Cost of Ownership or the Benefit of Relationship
Emiliano Era, GIS International, Chief Supply Chain Officer
Total Cost of Ownership (TCO) for Procurement can be defined as the Total of all Costs created by purchasing goods and services to meet the business targets of the company. This rather abstract definition can best be clarified by an example.
What is the cost to procure a new mechanical component, according to specs and technical drawings, from a new exotic supplier, including the cost for air freight and a delivery ready for production within 12 weeks?
The price is clear on the invoice, but the TCO will be completely different (and much higher).
Indeed, the TCO is built up of 2 elements:
- easy to quantify.
- complex to quantify.
The “easy to quantify” elements are: purchased price, transport price, inventory cost, duties, insurance, exchange rates, incoterms, volumes dependency and many other elements. These parameters are commonly applied by traditional buyers.
The “complex to quantify” exists of the technology capabilities of the supplier to stick to the technical specification, his quality level, his delivery reliability, his experience and strategy, and on top, his flexibility to deliver on a short time notice when exceptionally required due to a changing environment and new forecast conditions.
Also, the level of standardization and commonality between production plants, the number of articles designed-in, the sole source in-phasing articles becomes a major part of this complex quantification.
Companies often have a one dimensional view on Procurement which in most cases is also the short term view. While this is enough for one-off buys, it will work counterproductive in the long term.
The speed of business continues to accelerate. Innovation and competition help to improve operations, products, services, and supply chains. But at the same time, this results also in an increased volatility and complexity in the supply chain.
The current advanced Procurement technologies can support the management of this complexity and to standardize processes and requirements. But the question is if Procurement staff is sufficiently involved with Engineering, R&D or the technical department? Does Procurement have enough past experience or maturity to bridge Procurement with Engineering? Who is in charge of “Procurement Engineering” at the buyer’s organization, a critical question that organizations should address.
A NEW STATE OF MIND IS NEEDED
The market teaches us that success will be determined by a first pass success and by flexibility. It means that companies will struggle to be first on the market at the lowest TCO.
In the concept phase of the final product, freedom of specification is consumed very fast via multi-disciplinary teams (marketing, engineering, procurement, industrialization, ….) in one-itinerary solutions with built-in ultimate flexibility. The price becomes a second ranked element.
To realize the above TCO strategy, a limited number of supplier-partners are required, with the need of a strategic partnership both in the concept phase as in the execution phase. A change of attitude in Procurement is ongoing, realizing that competitive advantages and growth can be realized and sustained by a strategic approach towards a “benefit of relationship” with key vendors.
This approach is at the same time valid for the in-company world, being the valuable employees: if a vendor is a “cost” or a “benefit”, the company has also a beneficial relationship with its employees. If we want a strong relationship with strategic vendors, we need at least a similar approach with employees and create a win-win situation with those who commit to deliver savings for the company.
In a cost of ownership approach, the easy to quantify play a predominant role. It is a bottom-up approach, where the material costs (the external costs), together with labor, burden (or the infrastructure cost) and overhead cost (the internal costs) give the total cost of sales.
In a non-competitive environment these “costs plus profit” fix the Selling price.
In a competitive environment the approach is different: the market price is known, and all “easy” or “complex” elements will be considered not as a cost but as a value to contribute to a mutual benefit: they will determine both the partner’s and the company’s competitive advantage.
The relationship with the internal and external sources of benefit will result in flexible, professional, and competitive companies.
Procurement organizations must play an important and a strategic role in managing these internal and external resources.
The above vision is already becoming a reality for some advanced Procurement organizations: they heavily reduced their supply base and selected a limited number of key partners-vendors, managed by selected high skilled Procurement professionals.
To be competitive tomorrow, an optimized relationship will be required.
To discuss how GIS International can help, contact us today and let’s discuss. Get in touch with us here.