15.4 Total Cost of Ownership

When making the outsourcing decision or comparing suppliers, many firms make the fundamental mistake of focusing only on the quoted price, ignoring the fact that many factors affect the total cost of using a supplier. For instance, suppliers have different replenishment lead times. Does it pay to select a more expensive supplier with a shorter lead time? Or consider suppliers that have different on-time performance. Is the more reliable supplier worth the few extra pennies it charges per piece?

In each of these instances, the price charged by the supplier is only one of many factors that affect the supply chain surplus. It is important to focus on the total cost of ownership (TCO) when selecting suppliers. TCO includes all supply chain costs of sourcing a good or service from a particular supplier and can be considered in three “buckets”—acquisition costs, ownership costs, and post-ownership costs. Acquisition costs include all costs associated with the purchase of material from a supplier until it reaches the buyer and is ready for use. These costs include the supplier price, supplier terms affecting financing costs, taxes and duties, delivery costs, and incoming quality costs. Acquisition costs should also include the overhead of managing the relationship and planning the purchases. Ownership costs include all costs associated with the purchased part from when it arrives from the supplier to when the finished product is sold to the customer. These costs include inventory costs, warehousing costs, manufacturing or conversion costs, production quality costs, and production cycle time costs. Post-ownership costs include all costs incurred by the firm after the finished product has reached the end customer. These costs include warranty costs, environmental costs, product liability costs, and reputational costs. When scoring and assessing suppliers, one can organize the factors influencing total cost, as shown in Table 15-2.

The performance of each potential source (including in-house production) must be rated on each of these factors because all affect the total cost of ownership. It is important to consider trends that may exist especially if some of the sources are located overseas; these include exchange rates, local inflation in material and labor cost, transportation costs, and tariffs. This is especially true today, given the rapid change in these factors. Goel, Moussavi, and Srivatsan (2008) point out that producing a mid-range server in Asia in 2003 would have produced significant savings relative to producing it in the United States. Between 2005 and 2008, though, ocean freight costs increased by 135 percent, the Chinese yuan appreciated by 18 percent, and Chinese manufacturing wages went up by 44 percent. By 2008, freight and labor costs had increased enough to make production in the United States cheaper than production in Asia. Until 2008, many manufacturers viewed offshoring as a necessity, given that the offshore prices were 25 to 40 percent lower than those of local suppliers. By 2008, however, many executives realized that longer supply chains, lack of visibility, quality problems, growing transportation costs, and rising wages in developing countries made sourcing from local suppliers much more attractive. The lower transportation distance further increases the attractiveness of local suppliers from an environmental perspective. Given that a sourcing decision is unlikely to be changed quickly, it is important to include trends and scenarios (see Chapter 6) in the total cost analysis.

The importance of taking the TCO perspective has helped several companies make better decisions, whereas in other cases, a focus on the purchase price has ended up increasing the total cost. Zara is an excellent example in which the willingness to pay a higher purchase price has resulted in a much lower cost of ownership. The company chose to source its trendiest products from company-owned factories in Europe even though the acquisition cost from Europe was about 40 percent more expensive than Asia. The European factories had short design-to-product cycle times of three to four weeks instead of the three to six months from Asia. The shorter cycle times allowed Zara to meet demand for its popular products while not overproducing items that were not selling. As a result, Zara was able to increase profits by selling about 85 percent of its products at full price while the industry average was closer to 60 percent.

A similar perspective allowed Benetton to design an effective sourcing strategy when it introduced postponement (see Chapter 12) into its knit garments in the 1980s. Traditionally, knit garments were made by knitting colored thread. To lower costs, the various stages of knitting were handled by several small family enterprises. Although this process lowered cost, the entire production process took up to six months. Benetton identified a new process in which garments could be knit from undyed thread and then dyed later, while maintaining quality. As discussed in Chapter 12, this postponement of dyeing allows the supply of colors to better match demand. Although postponement was better at matching supply with demand, it had a higher production cost. With a focus on TCO, however, Benetton identified tailored postponement (see Chapter 13) to be a more effective strategy. Benetton separated the predictable base load from the unpredictable portion of demand for each color. Benetton outsourced for the predictable base load, as it had done in the past, to lower acquisition costs. The longer lead times of the suppliers did not hurt total cost because the base load always sold out. For the uncertain portion of demand, however, any mismatch of supply and demand was likely to increase total cost. Thus, Benetton opted for the higher cost production method with postponement to produce the unpredictable portion of demand close to when it was needed. Benetton performed the postponed dyeing function inhouse so it could be very responsive in dyeing colors based on demand. This strategy of sourcing the predictable demand from low-cost third parties and the unpredictable portion of demand inhouse using a very responsive (though high-cost) process allowed Benetton to decrease the total cost of ownership.

Mattel is an example of a company that paid significant post-ownership costs because of the action of a supplier. In 2007, the company announced several major recalls of toys made in China that were contaminated with lead paint. A subcontractor hired to paint the toys had used paint from a nonauthorized paint supplier. Mattel announced a charge of $30 million to cover the cost of the recall. The company was also fined $2.3 million by the Consumer Product Safety Commission. Even though the impact on its reputation is hard to quantify, Mattel clearly paid a high price for this sourcing decision, which lowered its acquisition cost.

Nike is another example of a company that worked very hard to contain the negative reputational impact of actions at its suppliers. Nike’s business model is based on outsourcing its manufacturing. In the 1980s, Nike’s manufacturing was in Korea and Taiwan, which were then viewed as low-cost sources. As labor costs increased in these countries, though, Nike urged its contractors to move production to Indonesia, China, and Vietnam. In the early 1990s, several reports appeared of poor working conditions and wages below Indonesia’s minimum at a Nike subcontractor. After several years of protest, significant criticism, and weakness in demand, Nike started to take more decisive action in the late 1990s. Nike CEO Phil Knight announced an increase in the minimum age of workers, increased monitoring of suppliers, and the adoption of U.S. OSHA clean air standards in all supplier factories. The company performed many supplier audits and published a complete list of the factories with which it contracted. Even though these actions did increase the acquisition cost for Nike, they also helped turn around the company’s reputation. Companies that outsource can learn from the Mattel and Nike experiences that accounting for post-ownership costs can be very helpful when making sourcing decisions.

Key Point Supplier performance should be compared based on the impact on total cost of ownership. In addition to acquisition costs, ownership and post-ownership costs should also be considered. In many instances, a higher acquisition cost is more than compensated for by lower ownership and post-ownership costs.