Ownership Costs

Ownership Costs


Ownership costs are the costs, after the initial purchase, associated with the ongoing use of a purchased product or material. Ownership costs are both quantitative and qualitative. Examples of costs that are quantifiable include energy usage, scheduled maintenance, repair, and financing. Qualitative costs, although difficult to quantify, are important considerations in making purchases. Examples or qualitative costs include ease of use, aesthetic factors, and ergonomic factors. The sum of both types of costs may exceed the initial purchase price and have a significant bearing on cash flow, profitability, and even employee morale and productivity. Understanding and minimizing these costs can have strategic significance. A supply management professional considers the following additional cost categories before making a significant purchase decision.


            Downtime Costs


Make a purchase decision solely on the basis of the purchase price may have long-term implications, depending on the reason for the lower price. A seller may discount a premium item to move excess inventory and increase sales. It also may want to dump a troublesome product on an unsuspecting purchaser. A new entrant in the market may discount an unproven product in an effort to gain market share. Often the selling price is representative of the quality of the product; presumably, the higher the price, the higher the quality. Whatever the reason, the long-run costs associated with a purchase may include non-value-added downtime. Cost associated with downtime include, for example:


  • ·        Reduced production volume and idle resources in manufacturing environment. Downtime often is caused by unreliable and/or inflexible equipment or direct materials that are substandard or wrongly specified in the design stage. Downtime for an automobile production line can run $27,000 or more per minute.
  • ·        Opportunity cost of lost sales as a result of lower production volume.
  • ·        Goodwill costs cause by undelivered or late orders, resulting in unhappy customers.


Careful scrutiny or reliability and dependability problems can reduce the cost of downtime.


            Risk Costs


Weighing the risk of an inventory stock out in a retail or manufacturing business against the opportunity cost of maintaining excess inventory is an important issue. Keeping extra inventory just in case can be a stopgap decision or a needlessly costly move. In just-in-time literature, just-in0case inventory is treated as a form of waste that a company should endeavor to reduce or eliminate. Some costs of excess inventory include those with financing, reduced cash flow, lost interest on cash flow, obsolescence, theft, and additional floor space.


It is important to consider risk costs when purchasing from new suppliers; using new materials, processes, and equipment in manufacturing; hiring new employees; or choosing legal representation.


Careful investigation and the development of appropriate sources supply will reduce the inherent risk associated with the unknown, untried, and unproven. The appropriate place begins is in the planning or acquisition stage, in which a risk assessment study should be conducted. Spending up front to reduce risk is an investment in the long-run efficiency and profitability of any firm.


            Cycle Time Costs


Whether decreasing a new product’s time to market or increasing the number of items produced in an hour (throughput), reducing cycle time can increase profitability and return on investment (ROI) through lower costs. Practices that a supply management professional can employ that may have a significant impact include implementing JIT materials management, forming strategic alliances with key suppliers, and establishing cross-functional alliances within the organization. The Higher initial cost of establishing and implementing these goals will provide long-run savings in the cost of direct material, direct labor, and manufacturing overhead. In addition, qualitative savings may accrue in the form of a smoother-running, more user-friendly organization.


            Conversation Costs


Buying the wrong material, whether in quality, form, or design, can increase the cost of conservation. As was discussed earlier, material that is not optimized for the production process can increase labor and overhead use and thus, because throughput is decreased and the cost of maintaining the quality of the finished product is increased, the total cost of production is increased. In addition, machine time, labor requirements, scrap, and rework may add to the unit cost. Spending too little time and money in the acquisition of materials may result in spending more time and money during production.


Other areas that affect conversion costs include production methods, employee training and working environment, and methods of accounting for product costs, especially in the application of overhead costs to units product. A well-informed and well-trained supply management professional may have the ability to influence decision making in these areas when working in a cross-functional environment.


            Non-Value-Added Costs


Non-value-added costs flourish in most businesses. It is estimated that some 40 percent of all costs add little or no value. Examples of non-value-added activities that add costs to a product or service include the following:


  • ·        Moving and stockpiling batches of direct materials and work-in-progress inventory because of a poor factory layout, poor scheduling, and a variety of wastes that increase uncertainty in the outputs of the system.
  • ·        Maintaining cumbersome operating procedures that duplicate efforts and steps for no apparent reason
  • ·        Routing daily service appointments in a random fashion rather than designing routes that minimize travel time.

Total quality management (TQM), continuous improvement, activity based costing (ABC), and activity based management (ABM) are incremental change approaches that help identify non-value-added activities. Process reengineering is a more radical approach to change that focuses on simplification and elimination of wasted effort.


Supply management professionals with background in management, operations, manufacturing, finance information technology, and logistics are qualified to make suggestions to suppliers that reduce non-value-added costs. A successful strategy, when possible and cost-effective, is to visit a supplier’s manufacturing site and observe how production takes place. Careful scrutiny may reveal a number of non-value-added costs that the supplier can reduce or eliminate, thus allowing for negotiations on lowering the supplier’s price. Observing a service provider’s processes either on-site or at its place of operation may reveal non-value-added costs that, when eliminated, will provide savings for both parties.


            Supply Chain/Supply Network Costs


“ If you process-map a supply chain and examine the material movement alone, such as the ins and outs of material flow from one organization to another, you will find many opportunities to eliminate waste.” Of course waste adds unnecessary costs to purchased materials and services, as well as to logistics.


James E. Morehouse, a vice president for A. T. Kearney in Chicago, asserts that extended enterprises are beginning to develop and will hasten the development of improved efficiency and cost reductions along the supply chain. He believes that “organizations will be outsourcing transportation, purchasing operations, manufacturing, warehousing, order entry, and customer service. As a result, organizations will be more integrated with their suppliers and customers in order to manage the total supply chain from raw materials to the ultimate customer, the only source of revenue.” A supply management professional should consider the following interrelated areas for developing better strategies for cost reduction:


  • ·        Forecasting-Improving customer demand forecasting and sharing the information downstream will allow more efficient scheduling and inventory management.
  • ·        Administration-implementing EDI (electrical data interchange) within the organization and between members of the supply chain will facilitate communication, reducing purchasing time, paperwork, and errors.
  • ·        Transportation-Streamlining material movement through the chain will reduce supply chain cycle time.
  • ·        Inventory-Embracing a JIT-type philosophy will help reduce unnecessary stockpiling and movement of inventory; suppliers can share inventory type and level information.
  • ·        Manufacturing-Improving capital budgeting procedures and designing and developing manufacturing processes that provide quality, efficiency, and reliability will lower costs and improve quality.
  • ·        Customer service-Listening to the customer will help identify supply chain inefficiencies and blockages.
  • ·        Supplier selection and relationships-Determining the appropriate source of supply and type of relationship with each supplier will minimize administrative overhead and help the company focus on the lowest cost at the required quality.
  • ·        Global sourcing– Expanding sourcing internationally will provide cost savings and quality improvements by focusing on and international supplier’s comparative and advantage and utilizing EDI and low-cost transportation.


Well trained management professionals armed with this knowledge can bring fresh insight to the table when developing TCO models and negotiating the supply chain.