How to Understand the Basic of TCO

Executive Summary

  • TCO is easy to misunderstand, but in this article we will cover the basics.
  • TCO calculation is an easy topic which vendors deliberately confuse customers.

The Basics of TCO

Before we dive into the details of how TCO is performed and how it has influenced decision-making, let’s start off with the absolute basics of TCO.

What is Total Cost of Ownership?

Total cost of ownership, or TCO, is the complete cost of owning something. TCO can be rearward looking an accounting of what a purchase actually cost. However, in most cases a TCO analysis results in a forward projection or forecast. TCO for enterprise software is the overall sum of the costs of the four main TCO categories:

  1. Software Cost
  2. Hardware Cost
  3. Implementation Cost
  4. Maintenance Cost

The primary concept behind TCO is that often all costs are not considered or calculated when making purchasing decisions. The purchase of an automobile is a good example. If, for instance, a person were to

budget all of their current excess discretionary income for a car and use its purchase price as a budgetary guideline, they would soon run into trouble because an automobile has ongoing additional costs such as maintenance. Anyone who has owned a car, a house, a boat, or any capital expense item would know that it is all too easy to overlook maintenance costs when making a purchase. How often have you heard a friend declare that if they had known the full cost of an item, they never would have purchased it in the first place?

The Purchase Price

The purchase price is referred to as an explicit cost, meaning the cost is published, obvious, and easy to include when making a decision. However, a purchase implies many other costs, which may or may not be known at the time of purchase. Total cost of ownership attempts to combine all of the different categories of costs into one number and use that number for making decisions. TCO can change a decision about a purchase that, at fi rst glance, may seem less expensive than other alternatives but in the end is actually more expensive.

TCO is discussed in the abstract but is rarely calculated in reality. If you think back upon all of the purchases you made throughout your life, how many of them included the TCO on the price tag, along with the actual purchase price? There is a good reason (or good reasons) for this and they go by the names of sales and marketing.

Sales and Marketing and TCO

The primary objective of sales and marketing is to increase sales. Sales decrease when customers come to understand the TCO of their purchases. Every purchase has a particular ratio: the ratio of the costs to its benefits. In the customer’s mind, the lower this ratio (as this ratio is perceptual), the more likely it is that they will make a purchase. Sales and marketing work their magic by increasing the perceived benefit of a purchase while decreasing its perceived cost. Having the prospective customer place the purchase on a payment plan can further reduce the sting of the most explicit cost: the initial purchase price.

The last thing a company wants is for their prospective customers to know the total cost of an item. The one exception to this rule is if the vendor has a study that shows their product or service has a lower TCO than that of a competitor’s product or service. Some software vendors create a white paper that shows the results of a TCO analysis within their software category, and lo and beholdÑon every occasion they, of course, have the lowest TCO! Even so, such advertisements of TCO in any context are rare.

Who Should Perform a TCO Anaysis?

Obviously, TCO analysis should be produced by an independent source and not the entity that is selling the item. TCO is fundamentally a consumer concept, not a producer concept. Therefore the consumer or an entity with the consumer’s or purchaser’s interests at heart should perform the research and publish the results of the TCO. There is a research company that does this, but they serve the consumer market rather than the corporate market. This company is Consumer Reports. They perform TCO for consumer items. Consumer Reports is in a good position to do this because they take no advertising from any producer and only make their money from consumer subscriptions. The following is a TCO estimation for automobile ownership.

Consumer Reports calculations in seven common automotive categories show that the most expensive vehicle to run for five years is the Mercedes-Benz S550 at about $101,750. Consumer Reports calculated that the least expensive vehicle to run over five years was the Toyota Yaris with a manual transmission, at about $23,250.

One of the least expensive cars to own in our estimation is the small Honda Fit, which costs just over $5,300 a year to own for five years. It combines a relatively low purchase price with low depreciation, great fuel economy, excellent reliability, and fairly low maintenance and repair costs.

Paying more for a hybrid can save you money as long as you choose the right hybrid. Most mainstream hybrids that aren’t luxury or SUV models cost less to own over five years than their less expensive conventional counterparts. (Two exceptions are the Chevrolet Volt and Honda Insight. It takes six or seven years, respectively, to make up the added purchase price in fuel savings for those cars.)

Consumer Reports

These reports are valuable because they provide very actionable intelligence that consumers can use to make informed purchasing decisions and to avoid cars that have hidden maintenance costs. Consumer Reports is one of the few media entities that can say they are not swayed by vendor influence because they put a number of restrictions in place that are designed to counteract vendor influence. Consumer Reports goes to the extent of actually purchasing the products they review rather than relying upon free samples which is how almost all media entities operate that review products. This, of course, puts the media entity into the debt of the vendor, as well as allows the vendor to adjust the reviewed product so that it is perfect and different from the experience that the normal consumer would receive.

TCO Versus ROI

It is important not to confuse TCO with its close financial cousin: return on investment (ROI). Below is a definition of how TCO and ROI are related to one another.

TCO analysis is not a complete cost benefit analysis, however. TCO pays no attention to many kinds of business benefits that result from acquisitions, projects, or initiatives, such as increased sales revenues, faster information access, improved operational capability, improved competitiveness, or improved product quality. When TCO is the primary focus in decision support, it is assumed that such benefits are more or less the same for all decision options, and that management choices differ only in cost. Encyclopedia of Business Terms and Methods

In actuality, few software products provide identical benefits, and the more complex the product, the more variability between each alternativeÕs return on investment (ROI). The simplest items commodities are the easiest to compare, precisely because their properties (in this case physical properties) are uniform. This is why silver, tin, grain, cotton, etc. can be sold on commodity exchanges. In contrast, enterprise software is complex; each application has different implications for how well the software meets the business requirements in terms of functionality, effectiveness of the user interface, ease of integration with other applications, amount of support needed, and hardware requirements and those are just the major items. Frequently the variability or score of these different items is unknown during the software selection process.

How ROI and TCO are connected.

The Connection Between ROI and TCO

TCO is the base value for ROI. A TCO must be calculated before an ROI can be calculated. ROI is the formalized analysis of the universal ratio between costs and benefits, which I referred to previously, and is focused on both the revenue and the costs of an investment. Unlike TCO, ROI takes into account the benefits from an acquisition. This is brought up in a quote from Ian Campbell of Nucleus Research:

“The real problem with TCO is that it’s a metric that can’t be used to make a buying decision. TCO assesses costs without regard for the benefits. We buy based on value, and I would challenge you to think of an item you purchase in your daily lives based solely on lowest costs.”

While this is true, the ROI is based partially upon the TCO. Therefore, while I don’t propose that TCO is the end point of the analysis, it is important to know the TCO before moving on to other analyses. Secondly, the ROI of enterprise software is quite difficult because it means estimating the financial returns from software, which is an extremely complex endeavor. Calculation of ROI is complicated by the fact that the specific areas of functionality that will be leveraged by the company must be estimated, and then the net benefit of that functionality must be projected. This is the only way that we know of providing a differential ROI between competing applications in a software selection.

The General Understanding of ROI

It is interesting to read articles about ROI, and after reading through them just to find essentially nothing explained of how to estimate ROI. There is actually far less published on ROI than TCO. In one way this can be seen as curious as so much is spent on enterprise software, but it is considerably less curious when one appreciates how difficult it is to calculate an ROI. And, in fact, once you dig into the detail of ROI estimations, it turns out that there is not much there. Furthermore, there are both explicit and implicit benefits to software, and the ROI estimations that we have evaluated will bring up the explicit or the hard benefits only, as it is often considered too difficult to ascribe a number to the implicit or soft benefits.

Therefore, instead of producing ROI estimates, Software Decisions applies a rating system to the application, which is used in conjunction with the TCO estimate. These are the following:

  1. A Functionality Score
  2. An Implement-ability Score
  3. A Usability Score
  4. A Maintainability Score

This results in a composite score, which the client can weigh toward the factors that are most important to them, or they can simply apply an even twenty-five percent weight to each score. This still allows the value of the software to be estimated, but without the necessity for an ROI calculation. The combination of the TCO and the application’s composite score captures the multiple dimensions of the application and is an effective approach for making a determination on software.

A company typically looks for the highest ROI, and simply the lowest TCO. For example, an application with a higher TCO than a competing application can also have a higher ROI, making the product with the higher TCO the preferred choice.

Net Present Value and TCO

Financial analysts, and anyone who has taken a finance course, are familiar with performing net present value calculations (NPV ). NPV discounts the future benefits and future costs into present day numbers through the introduction of some interest rate, often the company’s cost of capital. We do not add net present value calculations along with TCO estimations. If we did, it would shift the emphasis somewhat to applications that have lower up-front costs, such as SaaS solutions that charge for software on the basis of a subscription and have low implementation costs. However, the TCO advantage of SaaS solutions based on TCO in comparison to on-premises applications is already overwhelming and would simply show further differences.

How NPV Can be Calculated

NPV can be calculated once the discount rate the company wants to use is applied, but in most cases it will not make a difference between competing applications within the same software category, or software categories that are competing with one another for funding. And actually, it’s rare to include NPV in the TCO estimation. NPV is the most accurate approach, but TCO estimations tend to contain so many assumptions that NPV tends to further complicate the analysis (as well as the reader’s ability to understand the analysis). Secondly, as I will discuss in more detail, when the TCO methodologies are normalized (that is, adjusted to be comparable), then TCO from different sources can be used quite effectively; this improves the overall usability of TCO for the broadest decision-making. But, if other sources of TCO do not use NPV, it does not make a lot of sense to use NPV for one’s own TCO estimation.

Thirdly, TCO is essentially a comparative exercise. When TCO is calculated and a company bases a software, hardware, or services purchase on that TCO analysis, they do not actually have to cut a check for the TCO amount when they make the purchase. The TCO estimation is a guideline for how the future costs should work out. Therefore, as long as the various TCO estimations have a similar basis, or are normalized, precise adjustments such as NPV are not necessary.

Consulting

TCO is a financial estimate intended to help buyers and owners determine the direct and indirect costs of a product or system. It is a management accounting concept that can be used in full cost accounting or even ecological economics where it includes social costs.

The definition is, of course, the easy part; the more difficult part to explain to people is why TCO is so important. The reason for the necessity of TCO is that the price tag on an item does not tell you a lot about that items long-term total cost. This is true generally, but enterprise software is the extreme example of this well-recognized purchasing reality. In fact, many different researchers have concluded that the software license cost will end up being less than 20% percent of the total amount the company will invest in the application (although the percentages vary quite a bit per software category and per individual software vendor).

Custom TCO Estimates and Consulting

  • Want Help with TCO for your Business?

    It is difficult for most companies to estimate TCO without outside advice. Vendors and consulting companies do not want their customers to know what they TCO is. Getting TCO advice from consulting companies leads to underestimated TCO. We do offer remote unbiased multi-dimension TCO estimation.

    This article is free, we do not answer questions for free. Filling out this form is for those that have a budget. If that describes you, just fill out the form below and we'll be in touch asap.

TCO Book

TCO3

Enterprise Software TCO: Calculating and Using Total Cost of Ownership for Decision Making

Getting to the Detail of TCO

One aspect of making a software purchasing decision is to compare the Total Cost of Ownership, or TCO, of the applications under consideration: what will the software cost you over its lifespan? But most companies don’t understand what dollar amounts to include in the TCO analysis or where to source these figures, or, if using TCO studies produced by consulting and IT analyst firms, how the TCO amounts were calculated and how to compare TCO across applications.

The Mechanics of TCO

Not only will this book help you appreciate the mechanics of TCO, but you will also gain insight as to the importance of TCO and understand how to strip away the biases and outside influences to make a real TCO comparison between applications.
By reading this book you will:
  • Understand why you need to look at TCO and not just ROI when making your purchasing decision.
  • Discover how an application, which at first glance may seem inexpensive when compared to its competition, could end up being more costly in the long run.
  • Gain an in-depth understanding of the cost, categories to include in an accurate and complete TCO analysis.
  • Learn why ERP systems are not a significant investment, based on their TCO.
  • Find out how to recognize and avoid superficial, incomplete or incorrect TCO analyses that could negatively impact your software purchase decision.
  • Appreciate the importance and cost-effectiveness of a TCO audit.
  • Learn how SCM Focus can provide you with unbiased and well-researched TCO analyses to assist you in your software selection.
Chapters
  • Chapter 1:  Introduction
  • Chapter 2:  The Basics of TCO
  • Chapter 3:  The State of Enterprise TCO
  • Chapter 4:  ERP: The Multi-Billion Dollar TCO Analysis Failure
  • Chapter 5:  The TCO Method Used by Software Decisions
  • Chapter 6:  Using TCO for Better Decision Making

How It Works

How It Works

Each TCO calculator is self-service allowing you to continually change different elements in order to see the impact on costs. They are designed to adjust to the specific project factors such as the number of users, the general level of customization, the number of post go live adjustments to the application, etc..

The TCO calculators can improve your ability to plan your purchase.

How It’s Unique

How It’s Unique

Our self-service calculators have been developed through detailed analysis verified by many years of project experience combined with all the available research – all in order to develop a series of uplifts to costs based upon inputs. The formulas used are nuanced, and do not simply “scale” in direct proportion with changes to the inputs.

  • Our TCO calculators are designed to scale to any sized implementation and different levels of implementation complexity and customization.
  • We offer a true TCO by estimating internal costs (such as the time spent by internal resources on implementation and support) as well as the external costs. In comparison with the very limited TCO studies that exist on enterprise software, our TCO calculations are easily the most comprehensive.
  • Having performed this analysis for many applications, we have brought key observations between these applications as well as between various software categories.

What Is Included

What Is Included

Each package is a combination of two analyses. The first analysis is the interactive TCO Calculator which is provides a total TCO based upon the individual costs of software costs, hardware costs, implementation costs, maintenance costs as well as Lifetime Improvement Costs (the costs of the estimated improvements and adjustments to the application over its lifetime). Both these individual component costs as well as the aggregate of all the costs constantly change given your input to the calculator.

What It Is

What It Is

This offering provides buyers with the detailed information they need to for both the total cost of ownership of a single application, as well as the comparative total cost of ownership between multiple applications. This is the only self service TCO calculator that exists on the Internet, and it is available currently for 57 of the most well known enterprise software applications. This calculator receives input from you and automatically adjusts the costs so that they are customized for your intended way of implementing and using the software.

Transforming a Complex Analysis into a Simple Cost Breakdown

Even though all of the calculations behind each TCO calculator are complex and have been extensively tested and validated, they are easy to use. All that you need is basic information about your project such as the number of projected users, whether the implementing is more simple or more complex, etc..

Each package covers a single application including a comprehensive total cost of ownership analysis that takes into account the following costs:

  • Software Costs
  • Hardware Costs
  • Implementation Costs
  • Maintenance Costs
  • Lifetime Improvement Costs