Tuesday, July 18, 2006

An Introduction to TCO

Earlier this week, Elaine commented on my article from last week How Much Can Outsourcing Really Save. Elaine writes:

“Frankly, there are so many articles published stating different outcome of offshoring and outsourcing ventures. More often than not, people are confused on which side to believe in and which is telling the truth or lying.”

Elaine is, of course, correct in the sense that the savings that can be derived from outsourcing will be debated forever. Although, I would maintain that no one is actually lying. It all depends on how you count the beans.

It is for this reason that I believe that the Total Cost of Ownership (TCO) model is the most effective at determining the cost impact of changing any administrative environment. Today, I’d like to introduce the concepts around TCO.

TCO was first introduced as a concept 10 years ago by the Gartner Group. It was used to determine the cost of maintaining a computer workstation. The cost that was determined was surprisingly high. Later, Arthur Andersen was commissioned to do a study to disprove it, and the controversy hasn’t died down since. Elaine’s comment can attest to that.

In 2003, I conducted a study while at PricewaterhouseCoopers, and determined that the average cost for producing a paycheck is $16 for companies that administered payroll inhouse. Again, this was a surprisingly high number and has caused its own controversy in the market.

The reason TCO identifies higher than anticipated costs is because it is specifically designed to capture ALL costs of production or administration.What are these costs? They are the costs associated with the people (labor) doing the administration, the people implementing the systems and the people maintaining the systems. We also include the costs that are associated with the employees but are not part of the salary (non labor) such as tax and benefits load, physical infrastructure (rent, utilities, property tax), general and administrative (telephone, computer, office supplies).

Costs are further identified as either one time costs or as ongoing / recurring costs. This is important because one time costs such as implementation costs or cost for upgrades can cause cost spikes in certain years. The onetime costs, therefore, are depreciated over a certain period of time. Theses costs are amortized over three years in the studies I have conducted.

Individual companies sometimes depreciate capital expenses over 5 or seven years.The costs that are considered will typically cross multiple departments and budgets within an organization. If a TCO model isn’t used to identify costs, typically only certain department costs will be included and the cost is understated. This is why TCO produces dramatically higher cost than expected.

The calculated costs can be represented in any number of ways. It can be on a per widget manner such as $16 per paycheck. It can be presented as a total cost over the expected useful lifetime of a product such as $40,000 for a car after principal, interest, maintenance, etc over 10 years (less for an American car), it can be expressed as an annual run rate ($3 million per year), or even on a per employee basis. You name it; it can probably be expressed in a different way.

And the funny thing about numbers, depending on the expression, the numbers can seem either really big or really small. $16 per paycheck may not seem like much unless you start thinking about a company that produces 1 million paychecks per year.The interesting thing about TCO in any case, is that it provides the ability to baseline costs in a holistic manner. Any change to the environment can then be evaluated more accurately as the impacts of all departments and processes can be evaluated. This is how TCO relates to ROI. It is also where the controversy takes on a life of its own as reasonable people can disagree on what impact change can have on a system. For instance, will automating a particular process result in a head count reduction of 1 or 2 people? Is the redeployment of personnel real cost savings? How do TCO and ROI relate to build an actual business case for change?

And of course, how do figures lie and liars figure? Over the next few weeks I will be going more in depth on these questions and on TCO. I welcome input from the readers to help me focus the discussion on what will be most helpful to you.

About the authorDonald Glade is President and Founder of Sourcing Analytics, Inc., an independent consulting firm specializing in helping companies optimize their HR / benefits / payroll service partnerships through relationship management, financial analysis, and process improvement.

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