Optimizing total cost of ownership

When total cost of ownership (TCO) is applied broadly, the tools and concepts enable users to make a measurable impact in plant operating costs and margins. Their value comes from refocusing decision-making processes based on price and purchase cost to consider all financial impacts associated with a decision.

The positive impact is achieved through two related activities, analysis and control. Life-cycle analysis, or total cost analysis, is about understanding the relationship between purchase costs, operating costs (including operating labor, energy, maintenance, and the opportunity cost of lost production), and residual values versus the age of equipment or components and versus alternative operating and maintenance practices.

Total cost control, also called life-cycle management, and value management, is built on life-cycle cost analysis. It involves manipulating the life-cycle cost relationships and variables to minimize the cost or maximize realized value from an asset. The variables include renewal/replacement intervals, servicing costs, failure consequences, asset redundancy, maintenance strategies, energy efficiency, design life service factor, etc.

Tools, such as engineering economics, remaining life estimates, statistical analysis, opportunity costing, and electronic spreadsheets are essential to effective life-cycle management. Engineering economics enable us to consider the time value of money when comparing alternatives, while life estimating provides common vocabulary and technical tools for relating physical and financial attributes of a plant component.

Opportunity costs expand life-cycle and total cost considerations to include financial losses from component downtime and loss of function. Statistics allow us to consider the variability of expected life-cycle costs estimates, and spreadsheets give us the ability to combine all of the tools to easily model financials for our alternative policies, strategies, and buying decisions.

Component life

Certainly, the concept of component life is at the heart of life-cycle management and total cost optimization. Actually, component life refers to three different but complementary concepts.

Physical life is the expected age of a component when the cost of a repair is, or will be, greater than the cost of replacement

Economic life is the age of a component when the present value of future life-cycle costs (i.e., maintenance, operations, energy, and opportunity costs) is expected to exceed the present value of life-cycle costs, including purchase cost, for a new component of the same design. Economic life never exceeds physical life

Technical life is the age of a component when it is technically obsolete. A component is technically obsolete when required parts or repair skills are no longer readily available. Similarly, a component is technically obsolete when a newer version of the component or newer technology offers significantly lower operating or life-cycle costs than the component in question. Since a component may become technically obsolete either before or after the initial wear-out period, technical life can be either greater or less than physical and economic life.

Life-cycle cost analysis

A total or life-cycle cost analysis normally evaluates numerous kinds of cash flows and financial impacts over the expected physical, economic, or technical life of a component or facility. They can include:

Engineering

Purchase costs, including freight, taxes, costs for purchasing, receiving, inspection, etc. and costs associated with expediting late deliveries and/or handling defective parts

Installation

Startup, debugging

Operations and maintenance training

Spare parts, tools, and maintenance materials

Operator labor

Maintenance labor

Fuel and energy

Lost earnings from unavailability (i.e., margin contribution or contribution to overhead and profit from incremental changes in product volume rather than net margins discounted by fixed costs)

External renewal, rebuild

Decommissioning and removal

Resale or disposal after removal.

Optional suppliers for the same part or component functionality can also be evaluated based on the total of these cost elements.

Life-cycle value analysis

A life-cycle value analysis is quite similar to a cost analysis. In a cost analysis, costs are usually positive numbers, and credits, such as the sale of a used asset upon retirement, are negative numbers. The value analysis reverses signs of the numbers and focuses on revenue generating assets such as production units rather than plant components, which do not create revenue generating products by themselves. In either case, the analyst forecasts costs and credits and searches for ways to reduce cost while increasing credits.

In an industrial environment, TCO and life-cycle analysis provide the best approach for making the following kinds of decisions:

Selection of alternative components (Except when the differences in options are limited to differences in price or lead times, all component purchase decisions should be based on some form of TCO analysis)

Selection of alternative process or system designs (e.g., with and without redundant components)

Evaluation of alternative maintenance strategies (Focus is usually on renewal or rebuild frequencies, but can also include selection/scheduling of condition-based maintenance, spare parts, etc.)

Fleet renewal frequencies

Repair versus replace decisions

End-of-useful-life decisions (e.g. when to retire an operating plant)

Selection of optional component or service suppliers.

Process

When applied to these decisions, TCO optimization follows a process. Here are the six steps.

1. Clarify alternatives

The key here is to gain a clear understanding of the scope of each alternative and to assure an “apples-to-apples” comparison. For example, it would be inappropriate to compare a plant component to a system of plant components unless the system and the component serve exactly the same function.

2. Establish discount rate

To properly compute net present values as the basis for decision making, the time value of money must be represented accurately with the appropriate discount rate. A common mistake is to use the prime interest rate instead of your company’s weighted average cost of capital (WACC). If in doubt, consult your chief financial officer.

3. Determine appropriate planning horizon

Evaluating alternatives over too long or too short of a planning horizon can also cause errors in net present value (NPV) computation. Generally, you want the planning horizon to be for the time period during which your decision among alternatives should apply. For example, if you are looking at alternative plant designs for a product that will be obsolete in 10 yr, use 10 yr as the planning horizon rather than 20 to 25.

Component and fleet renewal decisions are notable exceptions to this rule of thumb. When comparing options of unequal duration (e.g., replacing forklifts every 3 yr versus 5 yr), the planning horizon should be the smallest multiple of all options considered so there is an integral number of cycles for all options (e.g., 3 x 5, or 15 yr for the two forklift options).

4. Build life-cycle cost spreadsheets with cost estimates for alternatives

The norm is to create a spreadsheet for each alternative. The spreadsheet is a matrix showing a series of time-period cost estimates on a spreadsheet row for each of the cash flow or financial impact types discussed previously. In the far right of the spreadsheet, a cell computes NPV for the row, and a total NPV cell at the bottom of the spreadsheet computes the sum of NPV figures for each row.

Establishing the estimate of life, period maintenance costs, residual values, and the other life-cycle cost components can be a very involved process. However, the analysis rarely needs to be time consuming or expensive. The trick is to expend an appropriate level of effort. For example, if maintenance costs for two alternatives are unknown but believed to be equal, the ultimate decision will not be impacted by the maintenance costs. Spending effort to get a finely tuned and equivalent maintenance cost for the two alternatives will not change the answer and should be avoided.

It is often useful to engage suppliers in estimating the life-cycle cost elements. It is even better when you can convert their estimates to contractual terms or a performance contract in which the key elements are measured to determine the supplier’s ultimate compensation.

Many vendors offer software tools to help estimate component life and tally life-cycle costs. Although detailed discussion of the more sophisticated tools is beyond the scope of this primer, you would do well to search the Internet if your analysis requires more than a simple spreadsheet and/or simple cost element estimates.

5. Compare net present values of alternatives and select best

If the discount rate, the planning horizon, the period cost estimates, and the spreadsheet formulas are correct, the best decision is usually the alternative with the lowest total NPV for the costs. When the decision is for a different alternative, the reasons for that decision should be challenged vigorously.

6. Track cost and life versus assumptions updating decisions, if necessary

This is where control and management make a big difference. By tracking actuals versus assumptions and by considering the impact of changing circumstances, the need for re-examining life cycle based decisions can be detected quickly. When actual component lives are well less than planned, the post mortem should take the form of a root-cause analysis. Rather than automatically reworking the analysis, it is often more appropriate to change the environment to better match the assumed conditions.

Example

Total cost of ownership is a very effective tool for managing mobile equipment fleets. When comparing fleet alternatives, the factors that must be considered normally include new purchase cost, residual value (i.e. what you can sell it for when you replace it), utilization, maintenance and repair costs, fuel efficiency, operability, downtime opportunity costs, depreciation, economic life, and cost of capital.

This example considers two options for a front-end loader. Figure 1 shows total cost cash flows for buying the loader and replacing it every 3 yr. Figure 2 shows the financials for a 2-yr maintenance lease agreement. In both cases, you are starting with a trade-in and assuming the weighted average cost of capital is 15% (ignoring inflation). Compare the options over a 6-yr horizon because both options have an integral number of cycles in 6 yr.

In the own option, you have a purchase price of $75,000 with a trade-in every 3 yr. Depreciation credit is the tax break you get from depreciation, so calculate it as the product of annual depreciation and your tax rate. Downtime cost is the contribution to overhead and profit you expect to lose because of loader unavailability.

In the maintenance lease option, the lease costs include maintenance. Fuel costs are the same as for the own option. You have also negotiated temporary replacement of the loader by the lessor anytime the loader is unavailable longer than 3 hr. Consequently, the expected downtime costs are less, and you do not particularly care how often the lessor replaces the unit.

For each option, calculate the net present value for each of the cost cash flows and sum the net present values of total ownership costs for each option, as shown. Since the lease option has the lower NPV for total ownership costs, you can conclude that the maintenance lease option is the better option.

Where to start

If you are not currently using TCO or life-cycle analysis, your ultimate goal should be to apply the concepts to all decisions involving significant spends for maintenance services or materials and to decisions that can have a major impact on availability, safety, or environmental control. Figure 3 summarizes the suggested prioritization process.

Total Cost Of Ownership Assessment: Loader Own Option

Cost Category
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
NPV

Purchase Price
75,000

75,000

$121,928.17

Depreciation Credit
-10,000
-10,000
-10,000
-10,000
-10,000
-10,000
($37,844.83)

Maintenance Labor
2,400
4,000
4,400
2,400
4,000
4,400
$13,267.76

Parts & Supplies
2,000
2,500
3,000
2,500
2,500
3,000
$9,571.35

Fuel
5,000
5,000
5,000
5,000
5,000
5,000
$18,922.41

Downtime
3,500
4,200
9,800
3,500
4,200
9,800
$20,989.03

Trade-in Credit
-37,500

-37,500

($60,964.08)

Total NPV
$85,869.80

Total Cost Of Ownership Assessment: Maintenance Lease Option

Cost Category
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
NPV

Lease/Maintenance
20,000
20,000
20,000
20,000
20,000
20,000
$75,689.65

Depreciation Credit
0
0
0
0
0
0
$0.00

Maintenance Labor
0
0
0
0
0
0
$0.00

Parts & Supplies
0
0
0
0
0
0
$0.00

Fuel
5,000
5,000
5,000
5,000
5,000
5,000
$18,922.41

Downtime
3,500
3,500
3,500
3,500
3,500
9,800
$15,969.35

Trade-in Credit
-37,500
0
0
0
0

($32,608.70)

Total NPV
$77,972.72

Author Information

Jim Humphires is one of the most broadly experienced professionals in the field of operations and maintenance. With over 25 years in the industry, he has inspired step-change improvements in manufacturing, purchasing, materials management, quality, maintenance, engineering, human relations, training, and marketing.

Humphries earned his Bachelor of Science in Industrial and Systems Engineering from Georgia Institute of Technology. He is a licensed professional engineer in South Carolina and Virginia. He is also a Certified Plant Engineer, AIPE, and a Certified Systems Integrator, AIIE.

Brad McCaleb is an expert in equipment, fleet and tool management, and outsourcing. His track record includes eight years of marketing research and strategic planning in the industrial, telecommunications, government, heavy equipment, and engineering and construction markets. His responsibilities include directing the marketing effort and the company’s brand position as well as account management for AMECO’s fleet outsourcing business. McCaleb holds a Bachelor of Science in Marketing Management from Bob Jones University, Greenville, S.C.

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