TCO, Net Present Value Analysis, and Estimated Costs

TCO, Net Present Value Analysis, and Estimated Costs


When one is trying to consider the true TCO, one method of evaluating a potential capital investment is to combine the present values of the initial expenditure, the future revenue streams, and future expenditure streams. Analysts discount the positive and negative streams by using and interest rate that usually is referred to as the opportunity cost of holding capital: the minimum required rate of return a business expects to receive on its investment. The opportunity cast of capital is linked to the riskiness of the investment and the firm’s capital structure.


TCO and net present value (NPV) analysis are very similar in philosophy. Both are used in an attempt to estimate and analyze the acquisition cost, operating cost, and post-ownership costs in terms of value likely to be received by the company; in addition, NPV analysis is used to analyze revenues and other cash inflows. NPV uses the present value of a sum of future cash flows discounted by a required rate of return; the larger the positive net present value is, the more likely it is that the investment will return more than required over its life. A net present value of zero (NPV=0) is the point of indifference. An NPV greater then zero usually suggests that the investment should be accepted. A negative NPV indicates that the overall return will be less than the minimum rate of return required by the company for the investment.


A note about estimated costs: Since TCO and NPV analysis require estimates of future costs of cash outflows, their reliability in providing useful information is only as good as the quality of the input data. A well-conceived analysis relies on inputs provided by cross-functional representatives with specific knowledge of and interest in the subject of the analysis. The most interested team member should provide the estimate. For example, supply management provides data on the purchase price, planting engineering provides an estimate of potential downtime costs, marketing provides an estimate of support costs, manufacturing provides an estimate of productivity or efficiency costs, and so on. A good rule of thumb is to include relevant participants who want to be part of the process.


Another method of arriving at estimates is for the leader of the cross-functional team to propose a cost figure and submit it for discussion. Frequently, one or more team members will react by saying, “No, x is too much. It would be closer to y.” Two other approaches to arriving at the estimated costs are parametric and Delphi. Both approaches, when applied in a strict sense, ten to be needlessly costly.


Neither of these methods can quantify many intangible variables that may affect a choice between alternatives or influence the decision whether to proceed with an investment. For example, in choosing between a sports car and a sports utility vehicle, a cost analysis is often not enough. Many people use a vehicle to make a statement about themselves, and so ego may have more substance than cost in this instance. Similarly, a company may want to project an image that only an automobile with a higher TCO can provide. This image may or may not be quantifiable in terms of increased future sales or executive image. It can be difficult at times, if not impossible, to quantify cash inflows on purchases; in these instances, a strict NPV analysis may be pointless.