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PURCHASING: THE CORNERSTONE OF THE TOTAL COST OF OWNERSHIP CONCEPT by

Lisa M. Ellram and Sue Perrott Siferd Arizona State Univeristy

The total cost concept has been a popular topic in business school curricula in the past decade. In purchasing, the total cost concept also is referred to as the total cost of ownership or life cycle costing.' Purchasing textbooks from 1928^ and perhaps even earlier discuss the importance of considering cost related issues beyond price in choosing a supplier. Yet relatively little progress has been made in integrating the total cost concept into supplier selection and supply base management. What is the total cost of a purchasing decision made today? Before 1980, most American firms would answer that question by looking at the bottom line of a supply contract. A common criterion for selecting suppliers was to choose the lowest bidder. Conventional wisdom in U.S. firms dictated that a desire for low cost take precedence over quality. Acceptance of a relatively high defect rate was accompanied by a willingness to carry extra inventory. Inventory managers, expediters, and inspectors were very busy on shop and factory floors. Suppliers were pitted against each other, since the threat of losing a contract to a competitor was thought to be the best way to "keep a supplier in line." Buyers and suppliers typically had an adversarial relationship. Thus cooperation between buyer and seller was not only uncommon, but in some situations it could be considered illegal by lessening competition. In the early 1980s, attitudes began a shift that has resulted in a 180 degree tum. The "total cost of ownership" has now become a concept of great importance. Firms throughout the world know that they must no longer trade low cost to achieve high quality. They know that higher quality results when workers are empowered to inspect and correct their own work. They know that supplier coof)eration can

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result in long-term payoffs. While firms can show that quality has improved and cycle time, labor content, and inventory levels have been reduced, few have learned how to measure the bottom line effect of such improvements. Indeed, Manufacturing Control and Performance'^ documents many cases in which remarkable improvements in quality and productivity actually appeared to result in higher costs. Could it be that conventional wisdom of choosing the lowest price supplier was right after all? The authors think not! The authors agree with Kaplan's premise: "modem" cost accounting is the villain!-^ Thus, this paper will examine the total cost concept as an altemative to conventional cost accounting practices, which assign costs based on labor hours, machine hours, or other arbitrarily determined bases. The purpose of this article is fourfold. First, this paper will explain what the total cost of ownership (TCO) concept entails, and how the TCO concept has evolved. Second, the benefits of adopting a TCO perspective will be discussed. Next, we will explore, on a limited basis, the magnitude of the adoption of the TCO concept in purchasing practice, and how and where that TCO concept could be used in the purchasing function. Finally, this paper will discuss what steps need to be taken in order to implement a TCO approach that is workable within the purchasing function. THE TOTAL COST OF OWNERSHIP PERSPECTIVE DEFINED The TCO concept requires firms to consider the activities they undertake that cause them to incur costs. By analyzing fiows and activities within each process, a firm can identify which activities add value, and which do not. Further, a firm can determine explicitly which activities it performs and pays for intemally, versus activities perfonned by others that increase the price of purchased goods or services. Thus, a firm can identify the true cost of any activity, rather than simply the costs allocated or paid extemally for that activity.^ The TCO implies that all costs associated with the acquisition, use, and maintenance of an item be considered in evaluating that item and not just the purchase price. However, costs are often lumped together and allocated based on production units, direct labor hours, or some other factor, rather than based strictly on the relationship between the cost and activities performed. In product costing, the TCO concept has been used to assign storage, labor, and other costs based on activities involved rather than on a predetermined formula. The TCO is part

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of the total cost concept. A model relating key purchasing activities to the TCO concept is shown in Figure 1. Key purchasing activities have been divided into six major categories. Figure I also includes examples of activities in each category. Methods of Measuring/Assigning Costs Costs incurred by the fimi can be viewed in a number of ways. For example, costs can be viewed as direct versus indirect, or variable versus fixed. The definitions of variable versus fixed cost and direct versus indirect cost are based on the way the costs behave in relation to some activity over a given time period. Traditional definitions of these cost terms are shown in Table 1. These are conventions that have been used for years in accounting, and for assigning costs. Most fjeople do not think of costs in terms of whether they are direct or indirect. People understand that if a particular activity is performed, there will be a cost associated with that activity. Thus, activity-based costing is a practical starting point for understanding and analyzing costs. History of the Total Cost of Ownership Concept The TCO perspective is not a new concept; it has been discussed and practiced in some form for many years.^ Harriman pointed out that "the science of buying is recognizing...the longer range factors of fitness, interchangeability, renewals, replacements, general maintenance, wearing qualities, and cost per unit of utility." Unfortunately, the paper systems for tracking costs that existed in most firms through the 1960s prevented purchasing from obtaining data on the above cost categories by purchased item. Costs are often summarized and allocated. When firms began to implement computerized accounting and record keeping, the existing manual systems were simply automated. There was limited or no attention given to changing the previous manual allocation processes to refiect costs incurred by activity. Extemal reporting needs, such as accounting for inventory costs, work-in-process, and cost of goods sold, drove the accounting system. Limited attention was given to the information needs of intemal managers. The purchasing function has long been aware that some suppliers provide better service and are easier to do business with, thereby reducing the finn's intemal efforts and expenditures. However, there has been no systematic way of determining and measuring those costs. Purchasing managers who are interested in determining

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FKiURE 1 PURCHASING ACTIVITIES CONTRIBUTING TO THE TOTAL COST OF OWNERSHIP

MANAGEMENT
Activities related to Matiagemcnt Determination of purchasing strategy in conjunction with corporate strategy tlire. evaluate, promote, fire purchasing personnel C\x)rdinate with other functions Training of purchasing personnel Initial orient:ition QUALITY DKLIVERV (ingoing procedure changes Professional development Activities related to Delivery'^ ^Aclivilies related lo ( Accept delivery Select and approve Accept partial shipment Assess supplier performance Bxpedite late orders Undcrsiand suppliers' priKessc Arrange for correction of Maintain supplier relations incorrect orders Acijuit^ parts for rework Retum rejected pans Inspect incoming materials Dispose of scrap

PRICE
Activities related to Price Negotiate terms of contract with respect to: quantity quality delivery conditions freight costs purchase discounts contract length degree of ccx>rdinationy and cix>peration

roiAi- c().sT OI' OWNERSHIP

SERVICE
Activities related to Service Oversee installation of equipment Oversee maintenance Order pans for warranty repairs Involvement in customer trainini Maintain spare pans inventory for nonwarranty repairs Supply service manuals Conduct product recalls Respond to complaints ineral trouble shooting

COMMLMCATIONS

Aclisilies related lo ( ummunications Update forecasts and communicate to suppliers l^epare and send purchase order: hv mail, phone, fax. and electronic data interchange Maintenance of purchasing information system Match purchase orders with receipts Make invoice adjustments Bill back retumed items Maintain inventory records

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TABLE 1 TRADITIONAL COST CLASSIFICATION TERMS

Tetrn Fixed Cost Traditional Definition A cost that remains constant, regardless of activity level, over some time frame. Problem Costs that are not truly fixed may be arbitrarily lumped and allocated. Time frame determines whether a cost is truly ftxed. Variable Cost A cost that varies in direct proportion to some activity level. Costs are often assigned the wrong activity base. For example they are allocated on volume when it should be machine hours. Variable costs may be pooled and allocated, when they should be directly assigned based on activity. Semi-variable Cost A cost that contains both fixed and variable elements. For example, it may increase in increments, or steps, rather than directly with volume. A cost, variable, fixed, or semivariable, that can be directly attributed to some activity. A cost, variable, fixed or semivariable, that supports activities, but cannot be directly traced to any given activity. For example, factory lighting allows a number of activities to take place in the factory. A cost that changes, depending on the activity or decision made. Same problems as variable cost. A variable cost may be improperly classified as semi-variable due to lack of understanding of what drives the cost. Same problems as variable cost.

Direct Cost

Indirect Cost

Same problems as variable cost. Costs that are not fixed may be arbitrarily lumped and allocated. Costs may not be as "indirect" as they first seem, and an analysis could tie them directly to an activity. Lack of understanding or data causes firms to improperly overlook some relevant costs as unchanging with different aitematives.

Relevant Cost

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such costs frequently are told that this type of infonnation is unavailable, does not exist, or is only available on an aggregate basis. Infonnation on all costs must exi.st at some point, or they would never get into the computer system. For example, if materials shortages shut down a production line, and the line employees are still paid, the firm will experience an unfavorable direct labor variance. That unfavorable variance may be allocated to all products that were in production that day, week, or month. Yet that unfavorability was caused by the particular item that was being run on that particular line. Further, even if the unfavorability was allocated back to that product, the unfavorability was not due to direct labor, but rather to a materials shortage. Is it not logical to change that unfavorability against that material.' Further, if the shortage was due to poor supplier perfonnance, should not the excess costs associated with the shortage be charged against the cost of that material from that supplier, so that the firm has a valid record of the cause of the shortage? Such an expense is truly a cost of doing business with that particular supplier for that particular item. However, in most firms, the variance would appear as a direct labor variance. It would take a great deal of work and retracing of steps to determine what precisely had caused that variance in a year, a month, or perhaps even a week after the shortage occurred. The true cost of doing business with a particular supplier is thus lost in the accounting system of the firm. As is frequently observed, paying the supplier a lower price may increase the total cost of ownership, particularly in areas such as delivery reliability, quality, and after sale service support. Little work has been done to provide those in the purchasing area with a logical and consistent way to gather cost data on attributes beyond price. Further, little work has been done that discusses which attributes are important to measure in source selection and/or evaluation. BENEFITS OF USING A TOTAL COST OF OWNERSHIP APPROACH There are several key benefits to using the TCO approach. First, the TCO approach is logical and easy to understand. Second, the TCO approach brings the total cost of an item into perspective, so that an improved supplier selection decision can be made. Good supplier selection is critical given the high dollar expenditures of many firms on purchased goods and services. Third, information gained through

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the TCO model can provide important data for analyzing, negotiating, and reducing the total cost of purchasing an item. First, as discussed in the preceding section, the TCO model attempts to simplify the TCO approach by grouping cost components into related categories the same way in which costs are incurred. The TCO approach is a logical, activity-based method of analysis. The categorization by activity should make costs easier to understand and recognize, as well as collect. By separating intemal cost information by activity, the true cost of a particular activity is easier to discern. Thus, cost figures can be used with confidence and understanding in decision making. Elaborate tnanipulation and re-creation should not be required to use intemal cost information for decision making. Second, while some costs directly related to a particular material (e.g., scrap losses, reject, and rework) are charged to the product using that material, many costs (e.g., expediting and invoicing problems) are not. Unfortunately, such costs are often considered to be indirect or administrative costs. Consequently, such costs are not allocated directly to the items to which they were related. These costs instead become part of a pool of costs that may be allocated among all products, based on product volume, direct labor, machine hours, or other allocation bases. Thus true costs are distorted, and poor supplier selection decisions may be made. Poor decisions can be very costly to the firm. The costs that firms incur for purchased goods and services as a percentage of sales are high in many industries. In 1987, 53.8% of the sales price of manufactured goods was made up of purchased goods and services. For illustration, purchased goods as a percentage of the cost of goods sold was 76.3% in the non-ferrous industry, 60% in the transportation industry, and 55.1% for the paper products industry.^ Thus, as one would expect, price paid for purchased goods and services receives a great deal of attention in many industries. However, cost information is often incomplete because of the focus on price rather than the TCO and consequences of purchasing decisions. Third, related to an improved understanding and selection of suppliers, the TCO approach is a useful analysis, negotiation, and cost reduction tool. For example, the level of service a firm provides can have a significant impact on the cost of doing business with that supplier. A firm may monitor receipts versus open orders, and know what percentage of orders are shipped complete and accurate. However, few fimis actually monitor how much it costs them when an incomplete order is received. The costs might include follow-up on the problem, expediting, higher

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freight from two smaller shipments, duplicate paper work, and changing the schedule to accommodate the shortage. All of the preceding activities are disruptive, costly, and time-consuming to the firm. All costs are incurred specifically in doing business with a particular supplier. Thus, they should be added to the cost of materials which that supplier provides. More meaningful comparisons of the total cost of doing business with a supplier are thus available. In addition, a better understanding of the various cost components throughout the purchasing cycle can provide a basis for negotiation with a supplier. A firm that can document the costs of supplier service can use that infonnation as leverage to secure an offsetting price reduction or improved service. The same cost information may be u.sed to justify a redesign of the product or service so that the current supplier can provide better service or so that the firm can switch to a different supplier. Complete TCO information can also provide an important basis for analysis of opportunities to reduce cost. If late shipments are relatively more costly to the buyer than incomplete shipments, the fimi can request that shipments not be held up until the order can be completely filled. Thus, cost reduction opportunities can be uncovered and pursued more readily with the complete infonnation provided in the TCO approach to purchasing. The buyer needs a model with readily available cost information so that such decisions can be made quickly and intelligently. USAGE OF THE TOTAL COST OF OWNERSHIP APPROACH The usage of a TCO approach in purchasing is limited in actual practice. A recent survey explored the use of cost savings and analysis tools among randomly selected members of the National Association of Purchasing Management (NAPM). Of 521 surveys mailed, 114 usable surveys were retumed. yielding a response rate of approximately 25%. The survey asked high-level purchasing directors, vice-presidents, and managers about their perception of the TCO approach versus other analytical tools used in purchasing. Eighty-five percent of survey respondents indicated that they were familiar with the TCO approach. Sixty-nine percent of respondents indicated that they would be comfortable either using or interpreting the results from a TCO approach model. However, it was felt that the TCO approach

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received less top management emphasis and attention than most altemative analysis techniques, as illustrated in Table 2."' TABLE 2 PERCEIVED TOP MANAGEMENT EMPHASIS OF FINANCIAL TECHNIQUES* Relative Rank** Retum on Assets - ROA Payback - PB Retum on Equity - ROE Intemal Rate of Retum - IRR Net Present Value - NPV Discounted Payback - DPB Total Cost - TCA Value Analysis - VA 1 2 3 4 5 6*** 6*** 8

* Survey respondents representing the purchasing function ranked the techniques in order of their emphasis by top management. ** Rank where 1 is the most emphasized or frequently used. *** Represents a tie in ranking. n = 114 While this information is interesting, it is also helpful to know how many finns are actually using a TCO approach in purchasing goods and services. To expand upon the above survey and address that question, one of the researchers conducted two informal, non-random surveys. In the first survey, a group of approximately 120 persons from the Purchasing Management Association of Arizona who attended the April 1991 dinner meeting were asked to indicate whether their firm used a TCO model. Representatives from only one firm indicated that they have a TCO model in place.

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The second test of the prevalence of a TCO model was at the 76th Annual NAPM Intemational Conference and Exhibit in San Francisco in May of 1991. Persons attending a presentation discussing purchasing cost savings were asked to complete a short survey on the use of the TCO approach. Given their interest in purchasing cost savings and their attendance at such a conference, it is assumed that those responding to this survey would be more progressive in their costing approaches than the average purchasing function. There were 103 people who completed the survey. As shown in Table 3, only 18% of respondents have a formalized TCO approach for evaluating purchased items. While 25% definitely do not have a TCO model, approximately 58% indicate that they use an informal TCO approach to evaluate purchased items. One interpretation of these facts is that the purchasing function considers cost issues beyond price in decision making. However, the lack of a formalized approach can create inconsistencies in comparing the costs among suppliers as well as inconsistencies among purcha.ses. Without a formal approach, it is difficult and time consuming to determine cost figures. Such difficulties create inaccuracy and harm credibility. As indicated by the first survey cited, the purchasing function may feel relatively comfortable with the TCO approach. However, top management does not appear to have given such an approach much emphasis, partly due to inaccurate data and lack of a formalized model. In tum, purchasing does not fully implement the TCO approach because of lack of top management attention, and lack of data availability." As a first step, purchasing must identify the cost data needed to support the TCO approach. The required data must then be made readily available in a usable format. Such a task is no small matter. Historical cost accounting tradition is one barrier. However, many firms are breaking down that barrier. An additional barrier is lack of attention and understanding by the purchasing function of the key cost elements that should be part of the TCO model. These and other issues related to implementation are discussed in the next section. Cost Ratio Model A variation on the TCO model that has received the most attention m the purchasing literature is the cost-ratio approach. The cost-ratio model generally limits investigation of cost factors to include price, the costs associated with quality, and

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costs associated with delivery.'^'^ Clearly, TCO approaches encompass many additional factors, as we have illustrated in Figure 1.

TABLE 3 USE OF TOTAL COST OF OWNERSHIP IN EVALUATING PURCHASES Response Unsure Yes, Formal Model Yes, Informal Model No Total N = 103 Percentage Responding 0 18% 58% 24% 100%

As a result of the lack of hard data, purchasing's cost analysis is based on price and items actually tracked by the firm, such as rework costs. There is likely to be a "gut feel" for how the supplier performs in other areas, with little substantive evidence. "Gut feel" is subject to the recency affect, where one tends to remember and weight heavily the most recent experience with a particular supplier. Most recent behavior may or may not be relevant, depending on what factors have caused the behavior. To detemiine the total cost associated with doing business with a particular supplier, for a particular item, the cost factors contributing to the "gut feel" about the supplier must be identified and quantified. This information does exist, but some detective work and painful data collection may be necessary to establish it. For example, buyers may need to start logging time spent expediting and following up on problems. This time would then be charged against the material it related to, at least in purchasing records. These logs could give purchasing a better feel for the true TCO of dealing with a particular supplier.

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Zero Base Pricing Model Another variation of the TCO approach is Polaroid's Zero Base Pricing Model. ''* Zero Base Pricing looks at two major cost components: the purchase or acquisition price and the in-house costs. The in-house costs include those expenses the buying firm incurs in addition to the purchase price, in using the seller's product. Such costs include customer returns, lost sales, inbound transport, scrap, rework, yield loss and associated productivity losses, production, storage, and inspection. The goal of Zero Ba.se Pricing is to reduce the TCO. Zero Base Pricing dictates that all components of cost must be looked at in terms of what Burt et al."'' define as controllable and non-controllable elements. Z^ro Base Pricing further requires that the buying finn's entire product design and manufacturing process be scrutinized. Thus, Zero Base Pricing goes beyond the purchasing function to include other functional areas of the finn. Similar to Zero Base Pricing, the TCO approach requires that a firm look at all of the costs it incurs in purchasing a specific item from a specific supplier. These costs go beyond purchase price to include quality associated costs such as rework, inspection, delays; delivery associated costs such as timeliness, completeness, and lead time required; communications costs such as EDI and paper flow; and service-associated costs such as expediting due to poor delivery, follow-up on quality problems, and incorrect invoicing; and management costs of training, technology transfer and similar issues. As noted earlier in the paper, a diagram of this proposed model is shown in Figure 1. This model indicates a broad spectrum of some of the many costs of ownership. Not all costs would apply to ail situations. Further, additional costs may be imponant in some cases. The major difference between the TCO approach and zero base pricing is that the TCO approach focuses on understanding and tracking those costs that are incurred by the buying firm. Zero Base Pricing is inherently proactive, focusing more heavily on working with the supplier to reduce and manage TCO. As a firm begins to build a TCO model, the infonnation gathered will lead them to work with intemal customers and suppliers more effectively. IMPLEMENTATION Implementation of the TCO approach in purchasing begins with an understanding of the costs that affect a purchased item. While detennining the type of costs to

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include in the TCO approach is not difficult, certain costs are easy to overlook. The best way to avoid ignoring cost components is by diagramming the entire acquisition process, from the request of an item by the user, all the way through any returns or follow-up on credits, defective items, and invoicing problems. A Flowchart of Purchasing Activities Table 4 shows the formal activities that are typically found in a purchasing cycle. Also included in Table 4 are some examples of support activities that frequently must be performed in order to accomplish formal activities at each step. Many of these activities are included in Figure 1. Neither of these presentations are considered to be all inclusive. Their purpose is to be representative of activities in which purchasing organizations engage. In focusing on an analysis of both formal and support activities, an organization can understand which activities add value and which do not. In order to analyze the cost of these activities, it is essential to identify the inputs, processes, and outputs for each activity. An analysis of the flows of information, paper, employees, materials, and even customers through each activity is sure to uncover some nonessential steps that are currently being perfonned. A careful study of the resulting flowcharts will often lead to knowledge of which steps can be combined or eliminated. It is suggested that for time-consuming steps in each process or activity a firm should determine the reason for the performance of that step. There is nothing more fruitless than making an activity more efficient when the activity does not need to be perfonned at all. One of the important inputs to many of the processes involved in the purchasing function is likely to be the time of purchasing professionals and other employees. It may be necessary to perform a work sampling study in order to get a rough estimate of how much time is spent on various activities. Work sampling is a useful technique for providing estimates of how professional employees spend their time. For an explanation of how to design a work sampling study, see Krajewski and Ritzman.'* An analysis is not complete without making an effort to identify the underlying factors that drive the amount of time spent on an activity. In some cases there may be primary and secondary drivers. For example, time spent expediting orders for the factory may be attributed to poor supplier performance on delivery, which may be due to poor initial communications with the supplier regarding delivery requirements. It is important to note here that the buyer should not assume that

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TABLE 4 FORMAL AND SUPPORT ACTIVITIES IN A TYPICAL PURCHASING CYCLE

Formal Aclivities*

Support Activities** Need for item arises

Possible Cost Drivers***

Purchase Requisition Issued Item is formally requested by user after receipt of required approvals Check inventory records Research for possible suppliers Check for availability of item Confirm user requirements as to delivery date. quality, price Solicit price quotes, bids. or proposals Receive and open bids in prescribed fashion Hold meetings with suppliers Visit supplier sites Select and approve suppliers Conduct negotiations Interact with legal. financial, and accounting personnel as required Item complexity Item scarcity Item price Volume required Frequency of purchase Uniqueness ot item Legal requirements Organization requirements Location - yours and supplier's Familiarity with supplier Number of suppliers

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TABLE 4 (Continued)

Formal Activities* Purchase Order Issued Order is formally placed Formal notification to: Supplier User Accounts Payable Receiving Department Inventory Management (Note that no formal accounting system entry has yet been made.)

Support Activities**

Possible Cost Drivers***

Data physically entered into purchasing system: manually, electronically, or other Coaection of any errors noted by user or supplier

TVpe of purchasing systems - yours and supplier's Care taken in order placement Training of purchasing personnel Order complexity Type of purchasing contract such as: One time purchase order Blanket purchase order Standing purchase order Other cooperative arrangement

Order Conflrmation Received Supplier confirms receipts and acceptance of order Order confirmation is filed with copies of purchase order Phone calls and other communication may be required if timely notification is not received TVpe of purchasing systems Order complexity Sophistication of supplier Degree of cooperation between your firm and supplier Need for changes in quantity, delivery date, or item specifications arises Forecast uncertainty Production schedule instability F^duct cannot be manufactured as designed

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TABLE 4 (Continued)

Formal Activities* Change Order Issued Engineering change order to product specifications issued Request for change in delivery date or quantity received

Support Activities**

Possible Cost Drivers***

Many phone calls and other correspondence may result Renegotiating with supplier regarding price and other terms Confirmation of new terms with user Check legal and financiai implications

Complexity of the change Type of change Frequency of this sort of request to supplier Supplier unreliability Inability of supplier to forecast well

Purchase Order Amendment Issued Issue a formal revision to the original purchase order Notify the same parties as in issuance of the original May have legal and financial complications requiring interaction with other departments Requires more input lo the system, updating records and tiles Follow-up with necessary phone calls, meetings. and communications Investigation and expediting of lost or late orders Complexity of the change Number of items involved Type of change Impact of the change on schedules, costs. customer orders

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TABLE 4 (Continued)

Formal Activities* Receipt of Order Order is received, and formally documented with a receiving report Receiving report notes any discrepancies between receipt and order Determine quality of incoming shipment Payment made to carrier Formal entries to the inventory system must be made

Support Activities**

Possible Cost Drivers***

Resolution of discrepancies between receipt and order Damaged items returned Damage claims filed with carrier Billing adjustments negotiated Receiving ref)ort filed Purchasing system and other records updated Arrangements for check, cash or money order for transportation Receipt of invoice from supplier

Complexity of order Reliability of supplier Reliability of carrier Delivery date of order relative to due date Delivery arrangement with supplier Large lots Partial orders Small "just-in-time" deliveries "Dock-to-stock" arrangements

Payment for the Items Payment is made according to the terms of the agreement with the supplier Receipt of item may need vertification Correct billing errors Design of accounting system Degree of internal control over payment authorizations Reliability of supplier Agreement with supplier

Correct payment errors Accounts Payable makes the appropriate accounting Update files entries and authorizes issuance of the check for payment of the invoice

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TABLE 4 (Continued)

Formal Activities* Item is used In Production A formal entry is made to the inventory system charging production with the item

Support Activities**

Possible Cost Drivers***

Resolution of any dissatisfaction with the item by the user Updated approves supplier lists

Product design Supplier reliability Purchasing strategy Supplier approval process Production strategy

Repairs Under Warranty Cost of repair results in entries to the accounting system Order may be placed for spare parts using the usual purcha.se order system Make spare part supplier decisions Product complexity Product design Product reliability

* Formal activities are defined as resulting in paperwork or an entry to the formal purchasing or materials management system. ** Suppt)rt activities are all the activities that cau.se to occur or support formal activities, and consume purchasing resources. *** Cost drivers are characteristics of the products or processes that may be related to the level of resources consumed by the activities.

the costs of dealing with different suppliers are the satne. Indeed, the cost of placitig ati order or followitig up on a problem may be quite different among suppliers, depending upon how user friendly their systems are. Thus, a sampling of several suppliers should be made to detemiine which costs of doing business differ among suppliers.

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It is helpful to know all costs of a particular purchase for developing a true TCO. TCO analysis may provide opportunities for cost reduction and avoidance that are general to that purchase, rather than related to a specific item or supplier. It should be noted that when a cost is identified that is the same for all items and suppliers, knowledge of the magnitude of that cost should not affect the selection of a particular supplier or item. Thus, for supplier selection, the focus should be on costs that differ. Conceptualizing the Total Cost of Ownership Figure 1 and Table 4 can be used as a starting point for analyzing the firm's TCO issues from a purchasing perspective. The issues to include should be modified for the particular situation. Once the activities have been identified, the purchasing manager should spearhead an effort to determine: 1. Which activities consume the most time? 2. What are the costs of these activities? 3. What drives the level of these costs? 4. For which costs is infonnation readily available? Purchasing can begin to develop a TCO model based on available cost information. The use of predetermined overhead figures is to be avoided. Purchasing may not be aware of all the detailed cost data currently available. Thus, the purchasing manager should seek the cooperation of the controller to determine how known cost information has been computed and what information is available for TCO analysis. Frequently, microcomputers can aid the purchasing function in gathering cost data without relying on support from the accounting function. If limited infonnation is available, the focus initially should be on getting information for the costs that are relevant to decision making, for the costs that appear to be the largest, and for the costs that are most readily estimated. As previously mentioned, a work sampling study, conducted entirely within the purchasing function, can lead to estimates of time spent on various activities. To implement a TCO model fully, the cooperation of upper management and the accounting function is essential. In some firms, where the computerized costing and accounting system is set up in a flexible manner, it will be relatively easy to obtain much of the detailed cost information required to support the TCO approach. It may only be a matter of defining needs, refining the way cost information is

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classified in the computer system, and getting a repon put together to access and summarize the data automatically. In many firms, a major overhaul of the computerized costing system will be required. In most cases, any modifications to the system to support a TCO model need not affect anyone else's reponing, although other functions should be encouraged to subscribe to a TCO approach. Cooperation and suppon from production and inventory control, logistics, and customer service will strengthen the case for modifying the cost reporting system. Because of the key role of the purchasing function in obtaining inputs to the finn's processes, purchasing must take the initiative in obtaining interfunctional suppon for use of a TCO model. Major Systems Modiflcation If it appears that a major modification of the current costing system, or the development of an entire new program, will be required to develop a TCO approach, top management support is clearly needed. Before approaching top management, purchasing management should be fully prepared to present information on the importance of the TCO approach, and on the benefits that will accrue to the firm. If preliminary studies lead to estimates of cost savings, it is an excellent idea to present such data. The benefits will have to be weighed against the costs of modifying the system. Further, the interest and suppt)n of other functional areas within the ftrm will strengthen the case for modification. If suppon is lacking, or such a system does not appear to be cost beneficial at the current time, purchasing should let it be known that they desire such information in the future. When system modifications or upgrades are made, purchasing would like their request to be considered a.s pan of (he change. It is often more economical to make several changes simultaneously. However, purchasing should track those costs for which they have information on a microcomputer-based system and continue to develop its own analyses.

SUMMARY Until such time as the TCO approach can be fully implemented, purchasing should consider whatever cost data is available in analyzing sourcing aitematives and in making operations more efficient. By focusing on activities and associated cost drivers, purchasing can identify the goods and services that provide the firm

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with the lowest total cost of ownership. Because purchasing activities affect ail areas of the TCO, purchasing has a vested interest in taking the lead in designing, implementing, and utilizing such a model. The key benefit of implementing a TCO approach is improved supplier selection decisions. Given the magnitude of purchased cost for many firms, the TCO approach can make a significant contribution. The TCO approach represents a progressive, systematic approach to understanding, analyzing, managing, and reducing the total cost of ownership of materials, services, capital goods, or any purchased item. The TCO approach supports functional integration and communication from the design stage onward, as well as cooperation and communication between the buying and supplying firms. Such integration and communication provides the best understanding and infonnation to support the TCO approach. The total cost of ownership is one critical part of total cost analysis for a firm. Because of the significant portion of expense accounted for by purchased goods and services, no cost analysis is complete without a comprehensive understanding of the firm's TCO. Thus, the TCO approach represents an important way for the purchasing function to improve its performance and contribute to the competitiveness of the firm.

Author's note: The first author acknowledges support for this research from Arizona State University's faculty-grant-in-aid program. NOTES 'Michiel R. Leenders, Harold E. Fearon, and Wilbur B. England, Purchasing and Materials Management, 9th ed. (Homewood, 111.: Irwin Publishing, 1989). ^Norman F. Harriman, Principles of Scientific Purchasing, 1st ed. (New York: McGraw-Hill, 1928). ^Same reference as Note 1. ''Robert S. Kaplan, ed.. Measures for Manufacturing Excellence (Boston: Harvard Business School Press, 1990). ''Same reference as Note 4.

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^Michael R. Ostrenga, "Activities: The Focal Point of Total Cost Management," Management Accounting 71 (February 1990): 42-49. ^H. Thomas Johnson and Robert S. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting (Boston: Harvard Business School Press, 1987). *'Same reference as Note 2, at p. 21. ''jim Morgan, "The Leverage Behind Every Purchasing Pro," Purchasing 27 (October 1988): 21. '"Lisa M. Ellram, "The Role of the Purchasing Function in Purchasing Cost Savings Analysis," International Journal of Purchasing and Materials Management, 28 (Winter 1992): 26-33. "Same reference as Note 10. '^Same reference as Note 1. '^Ed Timmerman, "An Approach to Supplier Perfonnance Evaluation," you/oa/ of Purchasing and Materials Management 22 (Winter 1986): 2-8. ''David N. Burt, Warren E. Norquist. and Jimmy Anklesaria, Zf/v? Base Pricing (Chicago, III.: Probus Publishing, 1990). '''Same reference as Note 14. '^Lee J. Krajewski and Larry P. Ritzman, Operations Management, Strategy and Analysis. 2nd ed. (Reading, Mass.: Addison Wesley Publishing Company, 1990). ABOUT THE AUTHORS Lisa M. Ellram received her Ph.D. in logistics from Ohio State University. She is an assistant professor of purchasing and logistics management at Arizona State Universily. Her current research interests include the total cost of ownership, intemational supply chain management, and buyer-seller relationships. Sue Perrott Siferd received her Ph.D. in operations management from Ohio State University. She is an assistant professor of operations management at Arizona State University. Her current research interests include activity based costing, work-force flexibility, and the productivity of service functions in both the manufacturing and service sectors.