Total Cost of Ownership (TCO)

Worker Repairing Complex Machine
GettyImages/Hinterhaus Productions

The concept of Total Cost of Ownership (TCO) is important for both buyers and sellers in business. 

As a purchaser, the initial cost of acquiring the product may be relatively small when compared to the annual cost for maintenance and support. Effective managers research their products to establish an understanding of the expected total cost of ownership over the life expectancy of the offering. 

As a seller, your clients will typically compare your offerings versus competitors from a Total Cost of Ownership perspective.

Top salespeople understand their client's concern over TCO and build this into their proposals to assist the buyer in the evaluation process. 

The Basics of Total Cost of Ownership:

Total Cost of Ownership (TCO) is a calculation designed to help people make more informed financial decisions. Rather than just looking at the purchase price of an object, TCO looks at the complete cost from purchase to disposal. It adds to the initial purchase price other costs expected to be incurred during the life of the product, such as service, repair, and insurance. TCO is factored into cost benefit analysis.

Total Cost of Ownership Is Not New:

Although TCO is often referenced in connection with Information Technology (IT) the concept has been around for a long time. Total Cost of Ownership was regularly discussed in the elevator industry in the 1950's and 1960's. One author suggests the concept, if not the term can be traced back to Napoleon’s time when "engineers began to pay very close attention to issues like the effectiveness of cannons, how easily they were moved and repaired, and how long they lasted in active service".

Total Cost of Ownership in Different Industries:

The additional costs that must be added to the initial purchase price to calculate the total cost of ownership (TCO) vary by industry:

  • Information Technology Hardware: TCO has been used extensively in the acquisition of information technology hardware. Estimates for the TCO of hardware typically incorporated the estimated cost of out-of-warranty repairs; the cost of annual service agreements, and the prorated cost of additional hardware and software required to leverage the hardware. Today, many firms lease space from web services providers, eliminating large investments in hardware and reducing the annual costs and the TCO incurred for running a firm's software applications. 
  • Traditional Software Licensing: For much of the history of the software industry, it was was purchased based on an initial cost or license fee plus an annual software maintenance fee calculated as a percentage of the original license fee. This annual maintenance agreement included bug fixes and feature upgrades when made available. This type of perpetual licensing has lost popularity recently in favor of subscription based licensing where the client re-purchases the right to use the software on an annual basis. 
  • Automobile industry – Edmunds.com has a TCO calculator that adds depreciation, interest, taxes and fees, insurance premiums, fuel costs, maintenance, and repairs to the purchase price of a car or truck.
  • Financial industry – Many mutual funds and similar products charge quarterly management fees and/or have withdrawal charges. These indirect costs must be considered when calculating the true cost of these investments.

Considerations for Total Cost of Ownership Calculations:

There are a number of nuances to consider when striving to understand the TCO of any offering:

  • Hidden costs are a concern. For example, a new software package might require initial training for users and supplemental training for new users over time. 
  • The method of financing will impact the total cost of ownership and the accounting treatment for deductions, capitalized expenses and depreciation will impact a detailed TCO calculation. Work with your accounting or finance department to ensure you have a complete picture of all of the implications and costs or deductions associated with your purchase.
  • Do not forget labor costs. You may gain efficiencies from new investments, reducing overall operating costs. The benefits from the efficiencies may defray or outweigh the actual costs. Conversely, you may incur additional labor costs as a result of the investment. 
  • Total Cost of Ownership often changes over time. Your annual repair costs for an automobile will logically rise as it ages, as will the cost of servicing many different types of machines. Make certain to factor changes in costs over the expected useful life of the offering. 

    The Bottom Line:

    When making a financial comparison between two choices or among several choices, smart managers look at the total cost of ownership (TCO) not just the purchase price. TCO includes all the additional costs required to support and maintain the item purchased for its full useful life, reduced to an annual estimate.

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    Updated by Art Petty