Engineering Competence

Total cost beats lowest unit price

A product’s price tag might show the lowest price, but when was the last time you looked at what it costs to use that part in man-hours, maintenance and downtime? Total Cost of Ownership tools are here to show you how.

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A product’s price tag might show the lowest price, but when was the last time you looked at what it costs to use that part in man-hours, maintenance and downtime? Total Cost of Ownership tools are here to show you how.

Let’s say your company’s production line needs a new supply of widgets. In this scenario, brand A costs one euro per unit and brand B costs two euros per unit. Many purchasing departments today would choose brand A simply because it is half the price.

Brand B’s sales representative pays a visit, however, and shows you the total cost difference between the two brands. As opposed to brand A, the brand B widget does not need lubrication and uses less energy, saving a significant amount in annual expenses. Brand B is also easier to install, saving man-hours and thus more money per year, and it comes from a dependable supplier – as opposed to a little-known company whose support department is of little help. When translated into the estimated number of hours your maintenance staff will spend on the phone trying to get support from brand A, brand B’s sales rep shows that you’ll save an additional X euros per year.

Instead of basing your decision on unit price alone, you are thus using a model called Total Cost of Owner-ship, TCO, by which brand B uses his company’s knowledge to bring his product well under the actual total cost of brand A.

TCO is beginning to pick up speed as companies across all sectors discover how much money using it can save, and they realize that those supposed “price savings” never actually fall to the bottom line.

“If you look at the cost of a product you’re produ-cing, 50 to 75 percent of that cost is likely due to what you’re purchasing,” says James Anderson, professor at the renowned Kellogg School of Management at Northwestern University in Chicago. “People are looking at TCO to find ways to cut large parts of these costs or to get some advantage working with their suppliers or customers. Maintenance, repair and operating supply providers are also trying to get their customers to notice these overlooked cost elements to discover the real cost drivers.

“The concept has been around since the late 1960s but has never been widespread,” Anderson says. “Today, the greater availability of data makes it more attractive as a progressive, practical approach.”

But, says Tim Underhill, a former professor from Texas A&M University and now a consultant in TCO, “TCO is not effective unless it is used properly, however, and this takes time, patience and persistence.

“A lot of people grab a number out of the air,” he says. “They say, ‘We’re probably worth 40,000 euros.’ That works for a while, but more and more customers are trying to find out what’s real and based more on fact than guess work.”

Anderson was recently conducting research with focus groups in the Netherlands, where one businessman told him, “Nearly every supplier coming in the door now claims he will save me money. It’s a wonder I have any costs at all!”

To offer a total cost solution, a supplier must be able to show concrete results on a customer’s financial profit and loss statement in four typical places:

  • Revenues. Can downtime be reduced, production rates increased or time to market for new products reduced?
  • Expenditures. Can rejects be reduced, thus impacting raw material costs? Can repairs be reduced, thus impacting the cost of replacement parts?
  • People. Can maintenance time be reduced, thus freeing up employees to do other things?
  • Assets. Can cost of ownership of a machine or plant be reduced? This is similar to the ownership costs related to having a car, such as fuel, insurance, financing, general repairs and taxes.

“When I work with clients, the first thing I want them to understand is that these costs exist,” says Underhill. “I take something from their operation that is real to them – a steam leak, bearings, stock-outs – and walk them through where the costs are and what a potential solution could look like.”

The big challenge is developing a methodology and tool to calculate these types of costs, he says. “You must be able to prove to your customers that, based on their own customized operating parameters, they’ll save money by implementing these things.”

While a few advanced suppliers including SKF (see box) have developed their own tools for use with their clients, Underhill has developed what he believes is the only commercial product available to measure
total cost, SalesStrat.

Underhill says the No. 1 cost driver being measured today is simple reduction in price, such as switching from brand B to brand A, and reduced freight costs. TCO makes visible a wealth of other, more hidden
savings. One of the main cost drivers commonly not measured on large supply contracts, for instance, is the technical support provided at the local level.

“Every time a supplier solves a problem or finds a better product for a given problem or application, it should be documented,” Underhill says. “But this is very rarely done or measured in any way by the sales team. Therefore the corporate offices don’t know what’s actually happening down in the field in terms of savings. They can’t measure it, and the field doesn’t know how to measure it.”

Underhill says he knows one distributor that went to great lengths to map out every single piece of a customer’s equipment, and then he provided continuous and fast support to that customer. This was a great start to TCO, but the distributor only went part-way, neglecting to document the savings his company provided. This made his company vulnerable to a competitor. “It’s the additional work,” Underhill says. “People just don’t want to do it.”

When people do the work, however, TCO can save money beyond any company’s expectation. Underhill says the first client he helped with TCO was a supplier to Amoco, the oil company that is now BP.

“The supplier had a EUR 200,000 a year contract,” he says. “Within the first six months, they were able to bring Amoco EUR 200,000 in savings. So Amoco gave them a EUR 4 million contract. They were able to save Amoco EUR 800,000 within one year. Imagine the benefits for both the customer and supplier if the sales team could show these types of savings.”

Documented Solutions

SKF has developed its own program, Documented Solutions, to help its customers predict the real-world, annual net cost savings they could realize by using SKF products and services. It doesn’t take long for an SKF representative to show a company how a particular SKF solution or service can reduce its total cost of ownership (TCO).

The program allows companies to plug in their own numbers – materials, labour, downtime, energy costs, etc., making the forecasted savings more real.

“We can prove to potential customers that, based on their own customized operating parameters, we can save them money by implementing these things,” says Todd Snelgrove, SKF Global Manager, Documented Solutions.
“These days, you need to measure business on total cost,” Snelgrove adds. “Globally SKF has great brand recognition, and in reality this is based on our history of helping customers solve problems and save money. In the newer world of business today, we need to prove the value that we are creating for customers on a daily basis.

“Customers need to work with suppliers who can show new cost-saving improvement opportunities and help them implement strategies and programmes so that they can be better and more efficient,” Snelgrove says.
With SKF’s Documented Solutions program, total cost reductions are shown in areas such as reducing energy, lubrication, inventory, warranty costs, manpower, machine life, reliability, output and quality, downsizing equipment, speeding up the design process and other factors that affect the bottom line.

“Customers need to visually see that the price premium for some SKF products or services is really an investment in their bottom line and that it will have a payback and return on investment that is difficult to find anywhere else in their operations,” says Snelgrove.

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