A_Comparison_of_Total_Cost_of_Ownership_with_Two_Other_Costing_Models

It has been researched that purchasing costs constitute a large chunk of company expenditure, sometimes taking as much as 80% of production costs (Cousins et al. 2008). This therefore implies that purchasing costs are vital in the overall performance of the company. Many divisions such as finance, administration and logistics are usually involved in the process of procurement incorporating relationships with a number of suppliers ranging from arm’s length relationship to strategic partnerships (Lambert t al. 1996).The management of purchasing therefore constitutes management of a sizeable part of the organization (Zeng 2000). In recent time however, the role of the purchasing unit in many organizations has shifted dramatically. As purchasing is becoming more and more important in the scheme of events (Cousins and Spekman 2003), managers have had to focus on many other variables apart from the actual prices of goods and services from suppliers. While it has been argued that the role of management accounting in inter-organisational relationships is yet to be clearly determined (Dekker and Van Goor 2000), managers have come to recognize the concept of management accounting as critical in their make or buy decisions (Seal et al. 1999) and in the building of trust between parties in relationship (Tomkins 2001). Before now, the traditional accounting practices had come under heavy criticism for their inability to provide inter-organisational focus and the necessary costing information (Bast et al 2010). To provide the needed relevance and focus to the existing inter-organisational practices, a number of cost approaches have been developed. They include total cost of ownership (TCO), target costing (TC), activity based costing (ABC), direct product profitability (DPP) and cost-to-serve (CS). Kulmala et al. (2002) believe that these cost approaches can be applied in “finding lower cost solutions than would be possible if the firm and its buyers and suppliers attempted to reduce costs separately”. The concept of total Cost of ownership (TCO) has received remarkable interest as an effective method of monitoring hidden costs associated with supplier transactions (Ellram 1994a). Though several literature have emphasised the usefulness of TCO, it is however noteworthy that the use of this costing model in industry is relatively limited (Ferrin and Plank 2002). A previous research regarding the application of TCO within Dutch firms showed that a number of purchasing managers have insufficient experience in TCO application and value analysis (Wouters et al. 2005). A rational explanation for this could be that some managers are yet to recognize purchasing as a strategic function (Ellram and Siferd 1998). One possible reason for the limited use of TCO in industry could be the currently undifferentiated management approach (Zachariasen and Arlbjorn 2011). Current literature on TCO looks at the model from a focal perspective and thus limits the analysis of TCO to identifying pre- or post-transactions (Ellram 1993a), modelling frameworks (Degraeve et al 2000) and the selection of appropriate cost drivers (Ferrin and Plank 2002). There are many definitions of TCO in existing literature. One definition is that it is an innovative concept aimed at building an understanding of the real cost of doing business with a particular supplier for a particular good or service (Ellram 1994a). Another definition is that it is a method of quantifying all the costs involved with the purchase of goods or services from a given supplier (Degraeve and Roodhoft 1999a). The recurring decimal in the definitions is the use of TCO as a method of concentrating on the indirect procurement costs and lifecycle transactions that are related to suppliers. As a result, organizations are becoming more aware of the varied cost patterns in procurement units making the adoption of TCO crucial in vendor evaluation and selection, and in guiding strategic cost decisions (Degraeve et al. 2000). One benefit in the implementation of TCO in firms is the point that it offers a more effective way to clarify the supplier performance expectations for the firm as well as the suppliers. Other benefits include the provision of objective data in negotiations and a more focussed perspective towards supplier cooperation (Zachariassen and Arlbjorn 2011). • The intricate nature of TCO may hinder its wide adoption. Lack of easily accessible accounting and costing data in many firms is a major hindrance (Ellram 1995). There is however the possibility that this situation changes as more companies adopt activity based costing (Ellram 1994a). Another major issue is the fact that there is no standardized method of approaching TCO analysis. Studies indicate that the TCO models used differ remarkably by company and may even vary within firms depending on the nature of the item purchased or category of buy (Ellram 1993). Therefore, education and training may be required to support TCO efforts. Furthermore, a cultural change orientation from price in procurement towards understanding total cost implications. (Ellram 1993). The complexity of TCO is further heightened by the fact that TCO costs are usually situation specific. The costs that are related and significant to decision making often vary as a result of numerous factors – such as the size, importance and nature of the buy (Ellram 1994a).Some of the benefits of the adoption of a TCO approach include the following: • It provides excellent data during negotiations • A long term orientation is developed as emphasis is not strictly on pricing alone. • Opportunities are provided to justify initial higher prices based on quality if there are lower total costs in the long run. • There is an improvement in the understanding of the buyer regarding issues of supplier performance and cost structure. Another costing model for consideration is the Activity based costing (ABC). It has been defined as a method of costing and monitoring activities which involves the tracing of resource consumption and costing final outputs (CIMA 2000). In this costing model, activities have resources assigned to them and cost objects have activities assigned them based on consumption estimates. The attractiveness of this model lies with the rising awareness of the deficiencies of traditional accounting methods where indirect costs are attached to products on a volume related basis (Armstrong 2002), that is through indirect labour. The primary concern of ABC is the assignment of resource costs to cost objects (Blotcher et al. 2005); such as products services based on the activities that have been performed for the cost objects. A school of thought asserts that ABC assists in unravelling the true costs of business (Lin et al.2001) and provides support in decision making and cost control, better measures of profitability for products or channels and a more effective provision of controlling capacity costs (Blocher et al. 2005).There are however concerns regarding ABC’s implementation difficulties (Kaplan and Anderson 2004), the inability to identify activities that are value adding or non value adding activities in firms (Lalonde and Pohlen 1996) and the difficulty in capturing the complexity of total operations in firms (Kaplan and Anderson 2004). In relation to TCO, ABC can be considered as quite similar to TCO. TCO analysis enables us to quantify the costs associated with acquiring and using offerings (e.g freight, quality checks) and the costs associated with poor quality (e.g warranties and rejection)(Ellram 1995).Activites within the scope of TCO take place in the purchasing unit as well as some other units.. Just like activity-based costing, the cost drivers can be found at various levels .Although ABC and TCO are both costing approaches, the emphasis of TCO is on the firm’s interface with suppliers to support decision making related to sourcing strategy while ABC focuses more on internal activities (Wouters et al. 2005). Another remarkable difference between TCO and ABC is that in TCO, costs need to be captured more accurately: by item purchased and by supplier (Ellram 1995). Again it is important that we understand the various costs and tradeoffs associated with sourcing as many firms now place a greater emphasis on value based market offering, both from the buyer and seller point of view (Ulaga 2001). TCO also supports organizations in handling pressure from their own customer markets and ensuring the purchasing unit has a value orientation. TCO can therefore be viewed as extending the boundaries of ABC, where the firm relies on information provided by vendors, or deductions drawn from price quotations from suppliers for market offering changes (e.g changes in systems and supplementary services provided)(Wouters et al. 2005) Target costing (TC) is another costing approach widely used. It is a technique used by firms to strategically manage future profits (Bastl et al. 2010). The model has wide usage in inter- organisational cost management (Axelsson et al. 2002) and is applied in the new product development stage. (Ellram 2006). The selling price of a product is premised on the estimation an organisation makes regarding the market price that can be achieved. The total target cost provided for a product or service is then obtained by subtracting the desired profit from the estimated sales price (Ellram 2006). The first step in target costing is the identification of a product’s features and functionalities and then based on this, an estimate the sales price and profit can be calculated (Axelsson et al. 2002). The next step involves achieving the desired target cost at the product level (Cooper and Slagmulder, 1999). The third step involves apportioning target costs to each important element on the bill of materials by combining the estimated costs with the constraint of the overall target cost (Ellram 2006). One advantage target cost has over TCO is that in cases where the firms have a strategy of product differentiation, the use of a cost target costing can lead to lower costs without an impairment of design (Everaert and Bruggerman 2002) . One of the deficiencies of target costing involves its failure to incorporate the cost of capital into production-related decisions (Kee 2010) whereas TCO considers a more holistic cost approach in its outlook. Another constraint of target costing is that it can lead firms to excessive market segmentation, organizational conflict and longer development periods (Kato et al. 1995). One other limitation of target costing is that it is an iterative process (Kee 2010). The design team have to continually redesign and apply value engineering until the estimated cost is less than or equal to its allowable cost or further reductions in cost are no more possible. This may lead to an excessive waste on time and the design team may be subject to undue pressure. In conclusion, it must be noted that experience plays a significant role in the use of TCO information in complex multi attribute decision making. When experienced decision makers are given TCO information, there is a possibility that such managers are more likely to pay less attention to information to attributes not includes in the TCO Information. This implies that decision makers may give more attention to TCO as the overall decision criteria without consideration for the fact that such information may not be perfect. There is no doubt that the use of TCO information has managerial implications. An improved costing data that captures the financial impact by bringing together all the financially quantifiable attributes may be helpful in decision making but care should be taken that this information does not draw attention away from those elements that were not included. This implies that in introducing TCO information, managers should be made aware of any limitations. It is also necessary to highlight the position of excluded items in costing reports. Furthermore, discussions regarding newly recognized tradeoffs might be helpful as well as holding managers accountable for recognizing the tradeoffs that exist between financial and nonfinancial considerations in purchasing decisions.