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

Total Cost Issues in Contract Terms


Total cost issues are in almost every term and each term affects one or more 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
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.
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
Cost of insurance (claims affect rates)
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.
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.
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 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.

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.


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:

Present Value  = -----------------------
      ( 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.” 

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
1 year
2 years
3 years
4 years
5 years
6 years
8 years
10 years

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.