Purchase price is always important, but…

In Procurement, the critical factor underlying your negotiations with suppliers should be the total cost of ownership (TCO) of the item into your facilities.

Financial mistakes caused through not identifying TCO for a buy are more often publicised in government procurement, as spending public money tends to be transparent. Procurement activities in commercial businesses also contain TCO mistakes, but these can be more easily hidden from external view.

When buying from locations considered as low cost countries (LCC), under-estimating the total cost can occur because labour costs associated with production is often the main driver in the purchase decision. As some businesses have found, the cost to business reputation and brand image can far exceed the supposed savings of buying from a LCC.

Procurement activities typically require the buying of materials and intermediate items, capital items (e.g. production equipment or facilities), outsourcing the manufacture and delivery of a product, or renewing a current outsourced services contract. Within these activities, analysis of the TCO requires a breakdown of costs that is relative to the criticality of the buy – obviously, imported items will have more cost sectors.

TCO cost sectors

Purchase costs

This is the starting point for TCO – the negotiated price of the item and any discounted figure for volume purchases and on-time payment.

Financial Costs

• Trading terms: In addition to the unit cost of an item are the negotiated trading terms for payment; bank fees for ‘letter of credit’ or other types of trade financing or using the buyer credit rating to enable the supplier to gain credit
• Additional insurance premiums
• Currency exchange hedging costs
• Administration costs directly assigned to acquisition and movement of the item
• Value-Added Services: The cost of additional services available at suppliers or 3PLs which add value to the item at a lower cost than in-house. An example is garment hang-tags and price tickets which can be attached at the supplier or consolidation site (i.e. Store Ready Merchandise – SRM) at less cost than at the delivery warehouse or retail store.

Trade Regulation costs

• Trade incentives and restrictions: offered by the buying and selling countries, Including those established through trade agreements (FTAs) between countries or groups of countries. Also, the documentation requirements (and potential penalties for errors) for customs clearance in the importing country
• Import and export costs:These will include customs charges (including additional charges for examining freight), import duties, fumigation charges (if required) and customs brokerage services (at origin and destination).

Logistics costs

• The cost of transport and storage available by type, both internationally and domestically
• Transport time (which is inventory that cannot be accessed) and its affect on the cash-to-cash cycle
• The levels of flexibility (and increased charges) at the supplier to implement product modifications and enhancements and at logistics service providers (LSPs) for changing production and delivery plans
• Seasonal demand and supply fluctuations and seasonal adverse weather conditions that may affect the availability of space and its cost and transport availability
• Allowance for delays through the supply chains, which could result in expedited freight and higher charges required to meet customers’ delivery dates
• Inventory costs associated with holding as a:
  • form (e.g. raw materials, sub-assemblies, finished goods) and
  • function (e.g. postponement, seasonal, quick response)

Supply Chain IT and Communications

• The supplier’s IT capability (and potential additional costs to the buyer) concerning operations planning applications used and interfaces to the buyer’s systems for information sharing
• Internet and telephone/fax connections

Risk costs

• Buying from the selected supplier and maybe the supplier’s suppliers, which include sub-contractors, service providers, contract employment agencies, agents and consultants
• Buying from the country of supply
• Proximity of the supplier to the delivery location e.g. same or close time zones
• Language and cultural similarities and differences between the supplier and buyer. If there are issues with the quality of the product, operational processes or deliveries, they are more difficult to address with a supplier which has different language, cultures and time zones
• Supplier to pack the items so they arrive intact at the destination, as it is difficult, time consuming and expensive to return unwanted items. This may incur a higher buy price, but the cost will be less than receiving damaged items that cannot be used, sold or returned
• Employee costs for training, time away, travel costs and fatigue (e.g. jet lag) to visit, negotiate and work with international suppliers

These six cost sectors are (or should be) the responsibility of supply chain professionals working in Procurement, Operations Planning and Logistics; either as a group or in separate departments. Constructing the TCO list for the organisation and managing the TCO process should therefore be a supply chain responsibility.

To undertake the TCO, a structured approach is required to identify, track, calculate and analyse the data. This is similar to the requirement for a corporate Spend Analysis.  However, the financial elements in your TCO list will most likely be located in multiple locations within the internal accounting systems. These systems are designed for use by accountants, not supply chain and therefore not designed to extract or consolidate selected costs.

An investment is therefore required in a Spend Analysis application that is capable of operating across multiple systems (head office and subsidiaries/divisions) to gather and clean the financial transactions so that information is meaningful for analysis.

This information, plus market intelligence for selected potential suppliers and countries provide one aspect of visibility. By calculating and analysing the TCO situation, improved input is provided for more rational decisions about where items are made and distributed.