Framework library · Finance and valuation

Total cost of ownership

The purchase price is often a small part of what an option costs. Total cost of ownership adds implementation, running costs, the people needed to operate it and the cost of leaving at the end. It counts them year by year over the same period for every option, so that a cheap purchase with expensive running is not mistaken for a saving.

LevelFoundational
TimeHalf a day with procurement, finance and the team who will run it
Who to involveProcurement and finance, with the team who will operate the option and someone who has run a similar one.
Also calledTCO, whole-life cost, life-cycle cost, lifetime cost

Use it when

  • You are choosing between buying and running something yourself or taking it as a service, such as a mobile core network or data centre space.
  • Two vendors' prices differ, but so do their running, support or energy costs.
  • A contract is up for renewal and you want to compare staying with switching, including the cost of switching.
  • Finance needs the full cost of an option over its life, not only the capital budget.

Avoid it when

  • The options differ in what they deliver, not only in what they cost. Score the benefits with a weighted decision matrix, or compare NPV with investment appraisal.
  • The timing differs a lot between options and the amounts are large. The totals here are not discounted. Discount them with investment appraisal before deciding.
  • Costs depend heavily on volume, such as per-subscriber fees. Model two or three volume cases rather than one.

How to run it

  1. Fix the options and the period

    Name both options in the opening question and use the same period for both, long enough to include at least one refresh or renewal.

  2. List the costs by category

    Acquisition (purchase, licences), implementation (integration, migration), run (support, hosting, energy, fees), people (the staff to operate it) and exit (migrating out, termination).

  3. Put each cost in its year

    Year 0 is the year of the decision. Enter each amount in the year the cash goes out.

  4. Compare totals and final-year costs

    The totals show which option is cheaper over the period. The year 5 column in the table by option shows the running cost each one leaves you with.

  5. Test the costs that drive the difference

    Volume growth, staff costs and exit costs most often change the answer. Change them and see whether the ranking holds.

Work through it

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Mistakes to avoid

  • Leaving out people costs because the staff are already on the payroll. If the option needs their time, it costs their time.
  • Ignoring exit. Every option ends, and the cost of leaving a service or decommissioning equipment belongs in the comparison.
  • Comparing a vendor's best case with your own realistic case. Use the same standard of evidence for both options.
  • Ending the period just before a large refresh or a price step, which makes the option look cheaper than it will be to own.

Where it comes from

No single originator: the approach comes from purchasing and IT practice. Lisa M. Ellram set it out for purchasing in "Total Cost of Ownership: Elements and Implementation", International Journal of Purchasing and Materials Management 29(3), 1993, and "Total cost of ownership: an analysis approach for purchasing", International Journal of Physical Distribution and Logistics Management 25(8), 1995. Source.

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Further reading

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