Total cost of ownership is much more comprehensive. It includes all of those costs as well as others that are often overlooked; for example, costs
affecting cash flow, such as emergency airfreight and
travel to audit a supplier. TCO also considers inventory carrying costs and predictable future costs, such
as obsolete inventory.
Other costs that factor into TCO are not found in
financial statements. For example, there is an
“opportunity cost” associated with the inability to
respond quickly enough to customers’ demands for
certain quantities or features. Harder to predict are
risk-related costs, such as those caused by political
instability or natural disasters.
These are just a few examples; the list of potentially relevant costs is long. That, and the fact that
many of the costs are individually small, cannot be
found in financial statements, or cannot be easily
quantified by an accounting system, are among the
reasons why many companies make sourcing decisions based on factors that are far easier to measure
but do not provide a complete cost picture.
WHY TCO IS IMPORTANT NOW
Before the recent spate of supply chain shocks, many
companies were comfortable making sourcing decisions based only on wage rates or purchase prices.
They were willing to ignore other costs because the
wage/price gap between low-cost countries and
other manufacturing locations was so large.
However, because they mainly compared prices and
did not consider the entire cost of offshoring, that
strategy may not have been as profitable as they
believed.
This oversight is a common one. A 2009 survey
conducted by Archstone Consulting, for example,
found that 60 percent of manufacturers ignore 20
percent or more of the cost of offshoring.
1 Similarly,
61 percent of respondents to a 2010 survey conducted by the global consulting firm Accenture acknowledged the need to implement TCO.
2
This attitude may finally be starting to change.
One indication is that IDC Manufacturing Insights
analyst Simon Ellis included “a broader view of total
cost” that will encourage nearshoring and reshoring
in his “Top 10 Supply Chain Predictions for 2011”
list. “In the context of taking a broader view of total
cost, supply chain organizations will gain a new
appreciation for shortening lead times through
profitable proximity sourcing strategies,” Ellis
wrote.
3
The list of supply chain “shocks” at the beginning
of this article suggests why companies are increasingly interested in TCO as a tool for determining the
best sourcing strategy. Clearly, the relative costs and
risks of offshoring have changed, and therefore
some offshoring that was profitable in the past could
now be profitably reshored.
Business conditions are changing so quickly, in
fact, that some long-held assumptions about low-cost sourcing are rapidly becoming obsolete. For
example, companies are now questioning whether
China is still the most profitable location for manufacturing. Boston Consulting Group4 and
Accenture5 recently reported that net per-unit manufacturing costs in China are rapidly converging
with those in some U.S. states. One reason why is
that Chinese wages are rising 15 percent to 20 percent per year, but productivity remains below that in
U.S. factories. In addition, the yuan is gradually
appreciating (approximately 6 percent per year). It is
expected to rise faster as China fights an inflation
rate that is two to three times the U.S. rate and promotes a stronger currency in order to reduce the
cost of imports.
It is true that raw material costs are about the
same in both countries, and Chinese hourly wage
rates are expected to remain far below U.S. levels for
some time to come. But if companies take a total
cost of ownership view that includes both direct and
indirect costs and risks, then in many cases it will
not make sense for them to source from China.
However, China is not the only offshore manufacturing location where costs are rapidly rising, therefore those sources also merit reconsideration.
