Module 3

Shift #1: Ensure Spec & SOW Design for TCO

Shift #2: Structure the Solicitation for Performance Results & Supplier

Innovation

Shift #3: Use Cost Modeling to Select the Lowest TCO Supplier

Shift #4: Develop Supplier Performance Agreements

TCO

2Acquisition Cost vs Total Cost

Think about a car purchase.

Purchase price

Registration cost

Depreciation

Insurance

Fuel type required

Gas mileage

Cost of maintenance

Reliability

Resale value

Type of tires required

TCO is Not New!

Under Napoleon engineers

began to pay very close

attention to issues like the

effectiveness of cannons,

how easily they were

moved and repaired, and

how long they lasted in

active service.

What is Your Criteria for Board

Recommendations?

Potential TCO Issues With Low Cost Materials

Environmental risks, including spills and releases

Performance risks, including field failures

Higher maintenance costs

Lost revenue and profits due to downtime

Injury risks, due to increased personnel time allocation

Regulatory risks, which may involve fines and/or business interruptions

5

Potential TCO Issues With Low Cost Services

All of the following may come about, due to lesser training, experience, or service equipment:

Safety risks

Performance risks

Liability risks

Quality risks

Management cost

Rework costs

Public relations costs6

Acquisition Cost vs. Total Cost, cont

What sort of purchases have a total cost that is close to the acquisition cost?

What examples have you seen where total cost was underestimated?

How is Southwest Airlines continually profitable? Only 737s economies of scale, mechanics, parts Farthest gates, smart airport selection

No travel agents

Fuel purchasing strategies

Corporate culture

7

TCO Overruns Happen!

A critical audit today reveals the California Department of Transportation (Caltrans), is millions of dollars over budget

on construction projects. - April 28th, 2011 CBS 13

The bullet trains from Anaheim and Los Angeles to San Francisco will not cost $34 billion as originally estimated, or $43 billion as the

authority insisted just two years ago, but closer to $100 billion. - November 6th, 2011 LA Times

Calpers My Calpers project experiences $228 million in cost overruns LA Times, 9/17/2011

California courts Case Management System modified 100 times

with cost increasing from 260 million to 1.9 billion KRCA television 3/14/2012 and LA Times 4/2/2012

9Various Types of Costs

Financial Fixed Variable Switching Sunk Opportunity Controllable Uncontrollable Administrative

Purchasing

Direct

Indirect/Soft

Avoidance

10

Purchasing Costs Defined

Direct cost savings: The quantified value of negotiated price related contract

components (i.e. price reductions)

Indirect/soft cost savings: The quantified value of negotiated non-price related contract

components

Cost Avoidance (100% cost savings!): Reduction in demand Elimination of components of what is being purchased

All of the above should be based on what would have happened had purchasing not gotten involved

Indirect Savings

Indirect savings are the quantified worth of value added supplier concessions

Warranty, customer service support, payment term discounts, etc.

These can be calculated in one of two ways:

Financial analysis of actual benefits

Supplier documentation of normal charges

11

12

Indirect/Soft Cost Savings The Big Conundrum!

Ask the supplier what they would normally charge any other customer for the negotiated value add in question

Increase in warranty

Reduction in leadtime

Dedicated customer support headcount

Alternative is to do a cost model where savings are internal

Exs: Productivity savings, payment terms savings using WACC

Source: Ghamami, Omid Capturing Soft-Cost Savings, ISM eSide Supply Management, September/October 2010, Vol. 3, No. 5

What Types of Savings are These?

13

Negotiated Area Savings Type

(Direct, Indirect,

Avoidance)

How to Calculate(hint: there is more than

one answer for some of these)

Lead time reduced

from 2 weeks to 2

days

Indirect What they charge other customers

Reduced inventory costs

Warranty increased

from 2 years to 3

years

Indirect What they charge other customers

Average failure rate in year 3

Reduction in price of

equipment spares

Direct Difference between quoted price and new

price

Reducing SOW to

require 5 fewer

supplier personnel

Avoidance Costs eliminated as a result of SOW

modification

Always Calculate Savings % Based on the OLD

Contract Value

If a supplier wants to sell you widgets for $90K and you negotiate them to $60K what is your savings %?

Most purchasing professionals will divide savings ($30K) by the amount they will now spend ($60K) = 50%

The correct answer is $30K divided by what you WOULD HAVE spent had you not negotiated ($90K) = 33%

Cost Models

15

TCO Reduction

Must Cost

Should

CostBenchmarking

Total Cost

Used when you

KNOW that

price exceeds

budget under all

scenarios

Used when custom

product/service or

sole sourced

provider

Used when there

is a material

difference

between

acquisition cost

and total cost

Benchmarking is

best used for

undifferentiated

products/services

Should be used for custom products/services

Ideal is a collaborative process good supplier relationship is key!

Review of associated supplier cost structure Set this expectation up front!

Sign NDA if appropriate

Review of fair industry profit margins for their NAICS code(s) Use Moodys or S&P to find averages

Opportunity to take costs out of the equation!

Key decision point: where to stop/start analysis16

Should Cost Models

Getting Industry Average Profitability

Ask the supplier their NAICS code usually 6 digits

Focus on their division for conglomerates

Research industry average figures for that NAICS code

Standard & Poors

Moodys

Dunn & Bradstreet

17

18

Understanding Fixed Costs, Variable Costs, and

Average Fixed Costs

Production

$$

Cost

Fixed

Costs

Fixed Costs/

UnitVariable

Cost/Unit

Not to scale, lines will vary by situation

Discussing Fixed Costs With Supplier

First question to ask supplier:

Will you be needing to increase any fixed cost infrastructure to support this proposed volume of business?

If the answer is no, they are only incurring marginal costs to support your business

Fixed costs are already incurred

Two approaches (can be step function):

Marginal Cost vs supplier price (since fixed costs are sunk)

AFC + Marginal Cost vs Supplier Price 19

Must Cost Models

Should be used when budget is less than benchmarks and cost models

Cost models are target driven pricing models

Requires customer/buyer flexibility and close partnership with supplier

Works best with very low marginal cost products, such as software

Can result in innovative cost, SOW, & spec solutions, but can also result in stalemates

20

21

Total Cost Models

Should be used when significant internal costs are involved

Total Cost Model = Supplier Cost Model + post acquisition costs

Total cost of ownership is critical!

Key is understanding true internal costs of your own firm

Process mapping & cost allocation

Switching costs?

Administration costs?

Training costs?

Consulting/training costs?

Test Your Understanding

Would a cost model or BM be best for each of these? If cost model, which type? For which ones would you pursue MFC?

1. Procurement of commodity type product with low switching

costs Benchmarking + MFC

2. Custom services engineering solution Should Cost

3. Hiring of janitorial service to a specific SOW Benchmarking

4. Non-standard software that exceeds budget Must Cost

5. Decision to purchase a fleet of cars Total Cost + Benchmarking + MFC 22

23

Cost Modeling Tips

Have team in place that has visibility to various cost components

Start basic, and add complexity later Start with variable cost components exclusively attributable to your

demand

Cost models developed in cooperation with suppliers are most effective

Do what if cost model analysis instead of just what is Do Pareto analysis on data findings

Separate controllable from uncontrollable

24

Rules for Cost Models

Revision #s and dates, every time! ONE owner for the cost model ONE place where it resides All data variables categorized and documented

Fact Estimate Assumption

Documentation of where/when/from-whom each data point came from. Perform sensitivity analysis with estimates and assumptions Does the supplier selection recommendation change with the various

sensitivity variables?

Define All TCO Components

25

Purchase Price

Ownership Costs

TCO

Policy

Costs

Performance

Costs

Use Costs

Indirect Savings

Incurred

Costs

Calculating TCO Components

Attempts should be made to itemize every cost:

Supplier provided costs (price, payment discount, transportation, etc)

Next level analysis by supplier (warranty value, value engineering, etc)

Internal cost analysis (inventory, human resource, utilities, insurance, or other cost drivers)

Product cost analysis (quality, reliability, production rate, resale value, etc)

26

Performance Costs

27

Cost of non/late delivery

Cost of quality (too low AND too high)

Transportation and packaging

Inventory carrying costs

Administration costs

Supplier availability/flexibility/

Customer service

Installation and modification costs

Start up and switching costs

Operator or TAC training

Service & maintenance

Supplies and spare parts

Useful life

Scrap or trade-in value

Use Costs Ease of use

Time factors involved

Administration

Oversight

Training

Etc.

Any supplier or product/service factors that change final output

28

Incurred Costs

Any additional charges from supplier outside of purchase price

Expediting fee

Consulting fee

Training fees

Any other adders (this is a supplier negotiation tactic!)

29

Policy Costs

Costs associated with internal policy decisions, such as:

Recycled material use

Diverse supplier use

Green supplier use

Local supplier use

Material use or avoidance requirement

30

Hidden cost in TCO

Acquisition costs: the costs of identifying, selecting, ordering, receiving, inventorying, or paying for something.

Upgrade / Enhancement / Refurbishing costs

Reconfiguration costs.

Set up / Deployment costs: costs of configuring space, transporting, installing, setting up, integrating with other assets, outside services.

Operating costs: for example, human (operator) labor, or energy/fuel costs.

Change management costs: for example, costs of user orientation, user training, workflow/process change design and implementation.

Hidden costs (contd)

Infrastructure support costs: for example, costs brought by the acquisition for heating/cooling, lighting, or IT support.

Environmental impact costs: for example, costs of waste disposal/clean up, or pollution control, or the costs of environmental impact compliance reporting.

Insurance costs

Security costs:

Physical security, for example, security additions for a building, including new locks, secure entry doors, closed circuit television, and security guard services.

Electronic security, for example, security software applications or systems, offsite data backup, disaster recovery services, etc.

Financing costs: for example, loan interest and loan origination fees.

Disposal / Decommission costs.

Depreciation expense tax savings (a negative cost).

Performance Agreements

If contractor and agency share the same goals, risk is largely controlled and effective performance is

almost an inevitable outcome

This can only be done when performance results have been solicited and contract for!

Cost incentives

Cost incentives can be used by splitting cost savings

and adding a percentage of the savings to supplier

profit

Performance incentives

Performance incentives can be used by increasing vendor profit for increased performance

Example: An incentive was used to hasten the rebuilding of the 10 freeway after the Northridge

earthquake. Though it cost the state more for the

rebuilding, it saved money on other issues such as

increased traffic control that were required due to the

unavailability of the freeway.

The Bottom Line is Influencing the Board

Do your TCO analysis homework

Give your board information they can trust and justify

Dont acquiesce and revert to low bidder models

Paint a data picture that forces the board to tell you that a highest value decision needs to be made

Let the data do the talking for you!

Call to Action

1. Champion total cost instead of acquisition cost

analysis avoid cost overruns

2. Know when to use cost modeling and which type

3. Understand how to capture and report cost savings

4. Recognize and capture all TCO components

5. Wisely use performance incentives for TCO

advantage

Use This Knowledge to Influence Your Board!

Lets answer your questions!

Q&

A