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:
Discounts	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	Taxes
Investment Credits	Tooling Maintenance
Residual Tooling Value	Duties
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	Internet
Price	$24.94	$20.00	$22.95
Sales tax	$1.25	$0.00	$1.25
Mileage cost	10mi x .36 = $3.60	80mi x .36= $28.80	0
Ship & Handling	0	0	$5.95
Total Cost	$29.79	$48.80	$30.15

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

Total Cost Issues in Contract Terms

otal

Total cost issues are in almost every term and each term affects one or more cost issues.

CONTRACT TERM	COST ISSUES
Delivery term	Freight costs, Risk of loss, Duties other potential charges
Delivery Point ownership / risk of loss	Insurance costs, Losses
Payment period	Cash outlay, Time value of money
Advance Payments	Cash outlay, Time value of money
Minimum buy quantities	Inventory cost
Late payment charges	Cash outlay, time value of money
Electronic / wire transfers	Time value of money, Processing costs
Changes	Price, Obsolescence, Process costs and Scrap, Increased quality and inspection costs, Impact to production if not equal. Costs of re-work and recall if discovered after the fact, Cost of re-qualification or redesign to replace with an alternative if not equal.
One time NRE charges	Cash outlay, time value of money
Premiums for Materials pull in (requests shorter than lead time)	Cash outlay, time value of money, premium costs.
Lead times and standard flexibility	Inventory Cost
Reschedules or cancellations	Cash outlay, inventory costs, obsolescence
Excess/ Obsolete material disposition	Costs or cancellations, restocking, administrative costs, sales or re-brokering commissions, reduced value of materials etc.
Cancellations	Same issues as excess/obsolete above
Warranty scope	Warranty costs (returns, repairs, test, package etc) plus associated costs (re-work if populated on a board, costs of board replacement if re-work is not possible).
Warranty length	Warranty costs
Warranty exclusions	Warranty costs
Warranty response period	Spare parts inventory cost
No defect found charges	Cash outlay
Termination for cause	Dollar damages liability, inventory obsolescence, costs
Termination for convenience	Inventory obsolescence, costs,
Indemnification and IP Indemnification	Dollar damages liability, time value of money for payment.
Limitation of liability	Limit on direct damages for all potential causes unless otherwise specified
Insurance	Cost of insurance (claims affect rates)
Definitions	Definition of cost terms like direct cost, manufacturing value added, overhead, profit, that define the cost items. Risk based cost factor, where the failure to properly define an item may impact the responsibilities of the parties, who pays for certain costs associated with the item, etc.
Statement of Work, Specifications	Determines the cost of the product. Presents a cost risk is incomplete or inaccurate specifications exist. Cost is the potential for change, and the cost of changes, re-work, or scraping, what had been done.
Term	While time doesn’t impact cost, costs can be impacted by the term and if you are locked into a Supplier, you want a term that provides you price protection.
Liquidated  damages	Liquidated damages limits the amount of cost you may recover for a problem to the agreed or liquidated amount..

While Buyers may think of contracts as a lot of legal “mumble jumble”, what contracts really do is define which party is responsible for performing certain tasks (which have an associated cost) and which party must assume certain risks (which may also have a cost associated).  For example if you agreed to “EX Works” or "FOB Origin" delivery terms you have assumed responsibility for the following costs:

·       Shipment from the Supplier’s plant to the port

·       Export clearance from the country.

·       Shipment from the Supplier’s country to your country

·       Import clearance and duties at your country

·       Shipment from the import location, to your site.

In addition you have also assumed risk for any loss or damage in-transit from the time it leaves the Supplier’s dock until it arrives at your dock and if it lost or damaged that’s a cost to you, or you have also needed to assume the cost of insurances required to protect against that risk of loss. From a cash flow perspective, your responsibility for payment is normally calculated from the time that the Supplier ships the product, not when you actually have it, so it also cut into the value of your payment terms.

Each responsibility has a cost associated with them. The risks you assume will either have a cost associated with any actions you take to manage the risk, such as buying insurance to cover against loss or damage in-transit. If you don’t assume the cost for managing those risks, you wind up self-insuring against the risk and, if the risk occurs, you will sustain a much greater loss. If companies elect to self-insure, they may still add costs to reduce the risk, such as controlling the carriers that may be used, or specifying packaging requirements and materials, both with the intent of reducing the potential of in-transit loss or damage. In some instances the costs may not be visible to you. For example, when you purchase insurance, the rate that you pay is based on your claims history and risk. The more claims you have, the greater the rate you will pay. When you agreed to assume certain risks rather than have the Supplier assume them, you are potentially impacting the claims that may be made against your insurance, which can impact the rates you pay for all items you insure. 

Where would you use the Time Value of Money and Cost of Inventory, Cost of Quality and Life Cycle Cost calculations?

• To evaluate bids from Suppliers where the payment terms quoted vary significantly.
• When a Supplier quotes a requirement for advance or early payment terms.
• When a Supplier offers extended payment terms versus other Suppliers to understand the total cost impact.
• When the Supplier’s requirements would force you to carry un-necessary inventory (e.g. guaranteed volumes, take or pay requirements, lot size, minimum volume or minimum order requirements, less flexibility on cancellations or rescheduling, etc.).
• When the Supplier’s performance forces you to carry un-necessary inventory (e.g. quality problems, delivery problems, field failures and reliability problems)

From a negotiation perspective what you do is:

• Talk about requirements or performance in terms of real dollars.
• Highlight how their terms are impacting them from being competitive under a total cost perspective (using a value of money or cost of inventory analysis).
• Highlight how their performance is impacting them from being competitive (under a total cost perspective using a value of money or cost of inventory analysis).
• Show them that to get or keep the business they need to change both to be competitive, or they need to reduce their price so that when those factors are added in, under a total cost perspective, they will remain competitive.
• Seek a price reduction from the Supplier every time they do anything that drives up your costs, inventory levels etc.

TOTAL COST - TIME VALUE OF MONEY.

Money has a time value. The discussion of the time value of money usually comes up when one talks about investment. Accounting books discuss the time value of money around the value of receiving payment now versus receiving payment at some time in the future. In Procurement we make payments. Terms may require investment in inventory. We may also have situations where the Supplier is responsible to pay damages that may have a time value of money impact.

There is basically two different ways to look at the time value of money:

1) Comparison of receiving a dollar now versus receiving a dollar later

which is referred to as "present value".

2) Determining what we would have to invest now to receive a dollar at

a later date which is referred to as "discounting" or discounted cash flow.

Most calculators with MBA type functions will allow you to easily compute either present value or discounted value. To calculate the present value you would use the formula:

1

Present Value  = -----------------------

                        n

      ( 1 + Interest Rate)

"n" is the number of years

Example: If the interest rate was 12% and the period was three years the calculation would look like:

             1                                 1

-------------------------  =  ----------  =  .71179

1.12  x  1.12  x 1.12          1.4049

This means that a payment made in three years would be worth seventy one cents in today’s money.

A company should have three money values that you should be aware of:

1.     The "cost of money" is the rate you are paying or would have to pay if you borrowed.

2.     The "value of Money" is the rate of return that you would achieve if you invested that money. The value of money is higher that the cost of money.

3.     The "cost of Inventory" is the the "value of money" plus the carrying cost for the inventory.

The "value of money should be used in calculating the present value of items involving payments, credits, amortizing one time expenses, etc. The "cost of inventory" should be used in calculating the present value of items affecting inventory such as minimum order quantities, increased safety stock as a result of quality problems, extended lead times, etc.

Rates can be either "Nominal" (interest is not compounded) or "Effective" (with interest compounded). The values set by your company for cost of money, value of money and cost of inventory should be an effective rate so that you do not have to deal with the effect of compounding interest in calculations.

Sometimes the issue of time value of money exists in the subtleties of the language used or the changes Suppliers try to negotiate. For example compare the same commitment, but with one word inserted:

            “Supplier will pay all damages awarded.” 

                                     Versus 

            “Supplier will pay all damages finally awarded.”

What’s the difference?

The difference is when you will get paid. In the first sentence, once damages are awarded the Supplier must pay. In the second sentence, payment will occur at some point in the future after the Supplier no longer has any possible appeals so the award is final.  You will still get paid the award amount, but on a net present value basis you will get less.  Using a 12% value of money, here’s what that future payment would be worth from a net present value perspective based upon when it is paid.

Time to get paid	Current value of that payment commitment
Immediate	$1.00
1 year	$.89
2 years	$.79
3 years	$.71
4 years	$.63
5 years	$.56
6 years	$.50
8 years	$.40
10 years	$.38

The simple reason for the difference is the “compounding effect”. The compounding effect means that over time you will make interest or a return on your previously earned interest or return, so that return compounds over time. If you keep money you get the benefit of the compounding. If the Supplier keeps the money they get the benefit and that reduces the value to you.

Trumping language

In playing cards you can have a trumping suit that has priority over cards of all other suits.  In contracts you may have language that gets inserted in the agreement with the express intent of overriding or having priority over a commitment in the same or another section of the agreement. That type of language it referred to as trumping language.

There are four different types of common forms of trumping that can occur.

You can see language that contains exclusions to avoid doubt to establish and clarify the intent and in doing so override other terms. For example:

“For the avoidance of any doubt, Supplier’s maximum liability under this agreement shall not exceed $ ___________.

This would trump all provisions in the agreement where the Supplier might be liable.

You can have language that says something like “notwithstanding anything to the contrary”.  This overrides anything that’s contrary to it with respect to where its used.

You can have language similar to “except as otherwise provided”. This gives precedence to the otherwise provided language in the agreement.

You can have a proviso that qualifies or overrides the concept that precedes it. For example the proviso here is in red.:

“In no event will either party be liable to the other for any lost revenues, lost profits, incidental, indirect, consequential, special or punitive damages.This mutual Limitation of Liability does not limit the obligations and liability of Supplier provided in the Section titled Supplier Liability for Third Party Claims or the Subsection titled Epidemic Defects in this Base Agreement and/or SOW

First there is the broad limitation against all damages other than direct, but in the second sentence it overrides that for the specific sections listed.

When a Supplier proposes any trumping language it should raise a red flag and you should be checking what the impact of that trumping language will be on other terms that you may have agreed.  The most subtle and dangerous ones are “notwithstanding anything to the contrary” and “except as otherwise provided” as it requires you to search through the document to see what is really being committed. “Except as otherwise provided” could be nullifying the commitment being made in that section where its used and “notwithstanding anything to the contrary” can be overriding other commitments.