Total Cost of Ownership vs. Total Supplier Spend: Serving Different Functions

Recently, a newer employee working in supply chain at a public utility asked me the following:

"What is the difference between a Total Cost of Ownership and Total Supplier Spend? We need to cut costs next year and there is a line in the supplier’s scorecard for TCO but I don’t know what it means."

She was rightfully confused because what the utility wanted to accomplish and what it asked for were two different things. Unfortunately, the supply chain professional who developed the scorecard did not use accurate language when describing what information they wanted to collect and measure to reward supplier behavior.

The Purpose of Financial Analysis All financial analysis is based on a cost benefit analysis. Many of the more widely discussed analyses are performed by the customer. The supplier can play an important part in developing the analysis with the customer, and suppliers will have their own version of a cost benefit analysis to deliver the product or service.

The purpose of the cost benefit analysis is to understand the trade-offs between material savings (product or service), other operational costs associated with the product or service, and the risk criteria (i.e. delayed shipment or deployment) associated with the product or service, in order for a customer to make strategic supplier selections.

Proactive vs. Reactive Proactive analyses (i.e. Total Cost of Ownership, Total Landed Costs and Should Cost Analysis for products, and Activity Based and Best Value analysis for services) help provide the buying company with a more holistic approach to evaluating the purchase price.

On the other hand, Total Supplier Spend (TSS) is reactive. TSS is not a "cradle to grave" analysis of a capital purchase, or even an Activity Based Analysis. It is more like a budget to actual spend analysis.

With a TSS analysis, the buying organization seeks to reduce the amount it spends with that supplier over the life of their relationship. In other words, the buying organization budgeted $10 this year with ABC supplier, but it wants ABC to beat the budget and spend (invoice) less than $10. If ABC can do that, then the buying organization will give them a positive reflection on their scorecard and some sort of tangible or intangible reward.

Since it is not a proactive analysis, it is not used to prepare for a negotiation, but rather tracked over time post-award. What the utility wanted was a TSS analysis not a TCO analysis even though the scorecard used the initials TCO.

Getting a Total Cost of Ownership (TCO) Right The goal for conducting a TCO is to establish the "cradle to grave" costs of an item over the life of the item. This is especially helpful when making capital purchases of any kind. A total cost approach for services is an Activity Based Analysis. When properly done, a TCO (or Activity Based Analysis) is done as a cross functional team including finance, engineering and operations etc.

TCO is a proactive analysis, because it is performed before selecting a supplier to award it the business. Ideally, the supplier’s product or service will cost the buying company less over the life of the product or service.

Getting Total Supplier Spend (TSS) Right The utility’s goal was to reduce the amount it spent with a supplier year over year for a service in a multi-year agreement. To get that savings, the utility would need to do the following:

Track its operations to understand where it is creating rework, redundancies or inefficiencies. Work collaboratively with the supplier to reduce the supplier’s efforts within the buying company. Continuously improve its operations to coincide with the suppliers improvements.

In my opinion, the low hanging savings has been picked off of the branches. To realize year over year savings, companies have to work together to understand the nature of the work each company is performing and seek to make the work more efficient. Otherwise it is all too easy for both companies to manipulate the numbers to make it seem as if TSS had been reduced when in fact it has increased over time.