Friday, December 17, 2010

Total Cost, Life Cycle Cost & Supply Chain Cost

 In recent years companies began to better understand their costs, and substantially broader cost factors were considered in decisions. In Procurement we have moved from evaluations based strictly on price to evaluations based on landed cost, total cost, life cycle cost or the entire cost of the supply chain and value to the Customer.

In understanding total cost here are some simple definitions:
§  Price is what you pay.
§  Landed cost is the Price plus all distribution cost, duties, and other fees required to get the product to the point of use.
§  Total cost is a method by which you allocate the costs of the Supplier relationship. Total cost is the Landed Cost plus additions or deletions based upon the impact of the contract terms and Supplier’s performance.
§  Total Life Cycle cost is the Total Cost, plus all future costs associated with the purchase over the useful life of the item. As these are future costs, they need to be calculated on a net present value basis. Total Life Cycle Costs would include things like spare parts, repairs, consumable supplies, differences in operating hours, yields, consumption of energy, residual value, etc.
§  Total Supply or Value chain cost adds the fulfillment cost parameters to the concept of cost. It looks at not just the cost of getting the items to you, but the cost of getting the item to the end user. This cost includes the total life cycle cost, plus the transactional costs for remainder of supply chain. For example, if one supplier could perform direct fulfillment and another couldn’t, the comparison of the total Supply chain costs would be their cost plus your costs of fulfillment against the cost of the Supplier providing the turn-key operation.

These costs include both direct and indirect costs. The majority of indirect costs are made up of  several key factors – the Cost of Money, the Cost of Inventory, the Cost of Quality and the Cost Warranty/Reliability in some combination. The Cost of Money is the financing cost for the item or your value of money. You would be concerned with the Cost of Money if you had to pay in advance or have shorter payment terms or when the Supplier’s commitment to pay or provide something in the future. The Cost of Money also becomes part of the calculation of cost of inventory, cost of quality and cost of reliability as all of those require an investment in inventory. Cost of money is also important in determining total life cycles costs. Cost of Inventory is a combination of the cost of money for that inventory and the specific costs associated with that inventory such as warehouse costs, insurance, risk of loss, damage or obsolescence. Cost of Quality is a combination of the actual cost incurred in managing the quality problem at incoming, in-process, or in the field. It includes costs such as the increased cost of inspection, returns, re-work, field problems and the cost of inventory that those problems create. Cost of Reliability is similar to the cost of quality except if deals primarily with the cost of failures that occur in the field strictly from failure of product. Warranties can either increase or reduce the cost of reliability.

To do a form of Total Cost calculation, you allocate costs (both positive and negative) to many of factors that exist in a Supplier relationship. The sum is Total Cost of the Supplier relationship. Total Cost bring in costs that are driven by the contact terms, the Supplier’s performance or Supplier practices into either your sourcing decision, negotiation or cost management process. Here is an example of the types of cost factors that could be used in calculating the Total Cost based on whether they add to or reduce the cost.
Reductions to cost:
Additions to cost:
Advance Payments
Extended payment terms
Non-recurring engineering costs
Retained Payments
Set up costs
Quantity Discounts
Tooling Costs
Estimated Cost Reductions
Packaging Costs
Learning Curve Reductions
Price Fluctuations (Increases)
Price Fluctuations (Decreases)
Raw Material Adders and Surcharges
Positive Currency Fluctuations
Negative Currency Fluctuations
Tax Credits Available
Investment Credits
Tooling Maintenance
Residual Tooling Value
Export Credit (Duty Drawback)
Lead time
Poor Performance Credits
Delivery Performance
Vendor Stocking
Order/expedite Costs
Credits for Freight Problems
Risk of Loss
Loss Recovery
Freight Cost and Insurance
Freight Quantity Discounts
Delivery Time
Value of Extended Warranties
Delivery related Performance
Credits for Quality Problems
Quality Problems
Extended Reliability
Warranty limitations
Packaging Re-use savings
Premiums for Maintenance Cost

Premiums for Spare Parts

Premiums for Repairs

Inventory cost for Minimum Order Qty.

Technical Assistance Charges

Support Required from Internal Resources

Re-schedule premiums

Cancellation charges

Design Change Premiums

Test Equipment

Other One time charges

For an item to be a reduction to the Price, it needs to be a firm commitment (such as cost reductions or committed learning curve improvements), and it must provide value to the Buyer. For example, if the Supplier offers an extended warranty, that alone may not provide value to the Buyer if the Buyer will not use or get the benefit of the extended warranty. For an item to be an addition to the price it needs to add to the price, the Buyer’s costs or risks.

In day-to-day decision-making we each do a form of "Total Cost" evaluation. For example, in searching for the best source to purchase a toy for a birthday you might check out sites on the Internet and scan all of the newspaper ads in the Sunday paper to find the best price. You find three potential sources for your purchase. The Internet price is $22.95 plus $5.95 for shipping and handling. A local specialty store (5 mi. from your home has them available for $24.95. A discount store 40 miles from home in another state with no sales tax has them has them available for $20.00. In a simple total cost calculation the respective costs would be:

Specialty store
Discount Store
Sales tax
Mileage cost
10mi x .36 = $3.60
80mi x .36= $28.80
Ship & Handling
Total Cost

This is Total Cost in its simplest form.

Cost items may be one time, recurring, or may not apply to all units. Where items are a one-time cost, in determining the Total Cost you spread those one-time costs over the total estimated purchases to determine the impact of that one time cost. Included in one-time payments are items such as Non-recurring Engineering or design charges, initial set up costs, tooling cost, and unique test equipment or other charges that are in addition to the price and are not repeat costs.  For these one time costs you may need to evaluate whether it is better to amortize the costs into the purchase price or pay it separately. As not all costs are immediate, as part of this type of calculation you need to you need to look at the cost of money from an investment perspective and use calculations of net present value or discounted cash flow in your calculations

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