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Measuring and Reducing
Total Cost of Ownership

by Kirk Woodward

Copyright 2017, Faulkner Information Services. All
Rights Reserved.

Docid: 00017503

Publication Date: 1710

Report Type: IMPLEMENTATION

Preview

Total cost of ownership (TCO) is a comprehensive model designed to help
organizations compare, understand, and manage the
direct (i.e., budgeted) and the indirect (i.e., unbudgeted)
costs incurred in owning and using a system (for example, an IT component
throughout its lifecycle) or a process (for example, the manufacture of an
item). TCO recognizes that there are both direct and indirect costs that
must be considered. This report offers strategies for measuring
and reducing TCO.

Report Contents:

• Executive Summary
• Description
• Alternatives
• Possible Pitfalls
• Step-by-Step Implementation
• Web Links
• Related Reports

Executive Summary

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Total cost of ownership (TCO) is a comprehensive model that helps
organizations compare, understand, and manage the direct (i.e., budgeted)
and indirect (i.e., unbudgeted) costs incurred with owning and using a
process, for example, an IT component, throughout its lifecycle.
Organizations may otherwise emphasize the direct costs and overlook or
minimize the indirect costs. Determining TCO can be a complicated matter,
involving repeated examination of costs. On-line calculators are available
to assist with the task. The larger the organization and/or the task, the
more complex is the task of determining the true TCO. On the other hand,
the goal of TCO is not to come up with a precise dollar figure but to
determine how costs can be effectively reduced, or to select between
competing processes or systems.

 

Related Faulkner Reports

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The goal of a TCO analysis is two-fold. First, a TCO analysis
measures both the direct and indirect costs associated with the
acquisition and support of programs or systems, such as IT resources,
providing information needed to select between alternative solutions.
Second, a TCO analysis may be used to reduce those expenditures in a
manner consistent with enterprise plans and values, by clearly identifying
the areas of costs, many of which may otherwise be ignored or
unrecognized.

TCO is particularly useful in offering an effective framework for
estimating real system, network, and telecommunications costs, and for
evaluating potential system, network, and telecommunications technologies.

The need to understand and control IT costs is paramount. Today’s
network-centric computing environment is influenced by several factors,
all of which contribute to higher costs. These factors include:

• The demand for network bandwidth to support ever-expanding server
  farms.
• The effect of deploying a virtual environment on business operations.
• The explosion of Internet and intranet applications, and the hosting
  of applications in cloud environments.
• The rapid adoption of telecommuting, work-at-home, and other mobile
  business scenarios.
• The development of global supply, or value, chains.
• The prevailing influence of e-commerce.

TCO is the sum of direct costs and indirect costs, as illustrated in
Table 1.

Source: Computerworld

TCO is a useful tool in practical business decisions such as prioritizing
projects, selecting vendors, evaluating competitive bids, managing the
development life cycle, deciding whether to lease or buy equipment, and
overall budgeting decisions.

TCO is also useful as a learning tool. Thorough TCO analysis can:

• Reveal hidden costs of ownership. The fact is
  that personnel and other hidden costs are major factors in cost of
  ownership, as much as two-thirds of the total TCO by some estimates.
  Minimizing these factors can severely distort the total cost of a
  project or initiative.
• Spotlight potential cost problems. A well-done
  TCO analysis can reveal unsuspected costs and when appropriate lead to
  process improvements.

TCO does not offer a classic cost/benefit analysis, balancing business
costs against business benefits (such as increased sales or higher
quality). However, pairing TCO with return on investment (ROI) analysis
can provide both a cost and a benefit perspective, and such a pairing is
frequently recommended.

Description

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Total cost of ownership (TCO) is a comprehensive model that helps
organizations understand and manage the direct (i.e., budgeted) and
indirect (i.e., unbudgeted) costs incurred with owning and using a product
or system throughout its life cycle.

Direct and indirect costs share an “up and down”
relationship. Typically, cuts in direct expenses result in a rise of
indirect expenses. For every decrease in customer services, for example,
there is a corresponding increase in customer “self-services,” as
customers attempt to compensate for diminished levels of IT
support. (“Customers” can be either internal or external to the
organization.) this is an example of a classic tradeoff situation, one
that frequently results in zero or minimal net savings despite its
apparent advantages.

Direct Costs

Direct costs are usually divided into five categories:

• Hardware and Software – Including capital and lease
  expenses.
• Management – Including network, systems, and storage
  management expenses.
• Support – Including help desk and training expenses.
• Development – Including programming, testing, and
  documentation expenses.
• Communications – Including leased line, remote
  access, and Web hosting expenses.

Direct costs are normally budgeted and, therefore, known. Table 2
offers some examples of direct costs. In calculating TCO, these must be
calculated over time.

Indirect Costs

Indirect costs are normally unbudgeted and, therefore, often
unknown. They come in two basic forms:

• Customer Costs – Including self-support,
  self-learning, even self-development expenses. (Again, customers
  can be external or internal.)
• Downtime Costs – Including the loss of productivity
  and revenue due to planned or unplanned system or network outages.

Table 3 provides some examples of indirect costs.

Reducing TCO

In reducing TCO, cost elements cannot be viewed in
isolation. Knowing the relationships between direct costs and
indirect costs is critical. While the process of identifying and
quantifying TCO cost components can be difficult, the rule of thumb for
reducing TCO is simple: Start with the components that constitute the
greatest costs and determine if those costs can be reduced.

The following example may serve as a cautionary tale. Some years ago,
many organizations observed that a significant percentage of their
employees were using then-expensive PCs to browse the Internet, process
email, and perform other functions that less expensive thin-client
computers could accomplish. To reduce TCO, some of these organizations
deployed cheaper thin clients. From a pure cost perspective, the decision seemed
logical.

But reducing TCO is not just a matter of simple mathematics. At the same
time the thin client was introduced (and in part because of it), PC prices
dropped, rendering thin clients less attractive. Also, since thin
clients were less functional, some employees had to upgrade to new systems
as their job responsibilities expanded or became more complex. This
act of transitioning from one machine to another involved unanticipated
costs, including installation and training. The situation became further
confused as employees began to use personal computing devices for business
tasks, a situation that calls for new TCO study.

The ability to weigh and balance multiple cost considerations is key to
making effective TCO reduction decisions. While there are many
specific approaches to reducing TCO, there is one general strategy:

• Examine the higher cost elements first, because they have the greatest
  potential for savings.
• For any proposed reduction in direct costs, consider the impact on
  indirect costs.
• Since IT trends and technologies in particular change quickly, try to
  be a futurist. Ask whether a proposed reduction will make sense in
  six months, or a year, or two years.
• IT reductions affect the whole organization, not just the IT
  department. Solicit as much non-IT advice as possible.

Cloud Computing & TCO

TCO analysis can help enterprise planners determine whether it is more
cost-effective to continue to deliver an application service like customer
relationship management (CRM) on the premises, or to outsource the service
to a cloud provider.

While the cost comparison may be simple in the case of an existing
enterprise service (with a stable TCO), the analysis becomes more
complicated when a new or proposed service is considered. Since
on-premise development and deployment produces high cost, at least
initially, the cloud alternative may seem more attractive. Over time,
however, and with higher user volumes, the TCO of the on-premise solution
may decline – making it more attractive than the cloud implementation.

While initial costs of an on-site solution may seem to indicate that an
off-site solution offers price advantages, TCO analysis of longer
periods of time may actually show savings for on-site solutions in the
longer run, due to larger user populations and related factors. It should
also be noted that cloud computing does not always replace the current
computing infrastructure; sometimes it continues to run in parallel. If
this occurs, it can have a significant effect on TCO, as well on the
savings that cloud computing is supposed to produce.

Alternatives

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While TCO has gained large-scale acceptance, the search for alternative
kinds of financial metrics continues. Some of the alternatives include:

Per-Seat Cost of Specific End-to-End Services

Independent computer consultant Lenny Liebmann suggested a measure which
he describes as the “per-seat cost of specific end-to-end services,”
observing, for example, that a PC by itself does not have any return on
investment (ROI). It is the service, or services, that the PC
facilitates that offer value. The “per-seat” formulation purports to
give a more realistic account of the cost of services.

Rapid Economic Justification (REJ)

While current TCO models offer a high degree of precision, they are
frequently difficult, or at least time-consuming, to implement. With
speed and simplicity representing the next hurdle for TCO calculations, a
new framework, “rapid economic justification,” or REJ, has
emerged. The REJ process is based on the philosophy of “just enough
data,” lending itself to scenario planning exercises. REJ builds a
bridge of common language between IT workers and senior executives to
demonstrate how IT spending can benefit the
business. REJ itemizes benefits as well as costs. In this
respect, it is closer to a conventional ROI valuation. It must not be
used, however, as a justification for guesswork. REJ clearly is analogous
to agile programming methods.

Return On Investment (ROI)

Some TCO practitioners complain that the TCO concept is flawed because it
fails to account for the business benefits of IT costs, arguing, in
effect, that TCO calculations should incorporate the type of cost/benefit
analysis associated with ROI computations. The feeling is that the
cost-based TCO is “too negative.” The real problem is that TCO and ROI are
often viewed as either/or methodologies, when, in fact, as mentioned
above, they can effectively complement each other.

Simply put, an ROI analysis measures whether a particular investment is
worthwhile, or whether the benefits outweigh the costs. Having determined
that a particular investment is worthwhile, a TCO analysis helps pinpoint
the specific costs associated with that investment, leading, ultimately,
to a reduction or possibly elimination of those costs. ROI answers the
question “Should we do it?” TCO answers the questions “What are we doing?”
and “How can we do it better?”

Time To Value

Time To Value is the estimation of the time that may elapse between a
business request and the first delivery of the value of that request. Time
To Value is essentially a short term measurement, focused on the immediacy
of results, while TCO is most effective when able to measure factors
projected into the future. However, Time To Value is often used when
planning development through agile programming, an aim of which is to
achieve the maximum result possible in the shortest time. 

Profit and Loss (P&L) Statements

The scale of analysis required by TCO may make the use of traditional
profit and loss (P&L) statements attractive under some circumstances,
but their effectiveness in the process of selecting between alternatives
will depend on their proper identification. A P&L statement that
focuses on an area known to be crucial may shed significant light on its
value. However, in developing TCO, areas may be identified that would not
otherwise have been considered. A P&L statement may then be useful as
an adjunct to TCO analysis, but it should not be considered a complete
picture of TCO.

Inter-Enterprise TCO

In this era of business-to-business (B2B) e-commerce, global business
partners are not only sharing data, but systems and processes as
well. The goal is to design and implement hyper-efficient business
processes that are integrated in real-time and jointly owned by suppliers
and customers. This means elevating TCO and other systems management
disciplines to the proverbial “next level,” and identifying,
characterizing, and quantifying new sets of inter-enterprise costs. The
complexity of this task must not be underestimated, but the rewards may
also be significant.

Possible Pitfalls

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While TCO is a useful tool for evaluating IT investments, it also has
drawbacks. TCO can be difficult to measure, as intangible factors are by
their nature elusive, and the factors that affect TCO will almost
certainly change over time, making it necessary to periodically
recalculate it. In addition, the formulae for calculating TCO can be
daunting, and software packages are available to help in that process. As
a result of these factors, TCO can be labor intensive.

Lower TCO Does Not Mean Higher ROI

Managing TCO is frequently equated with reducing TCO. Managers often
assume, incorrectly, that lower TCO means higher ROI. In reality, there
are certain thresholds below which TCO should not be permitted to fall. A
network manager, for example, could reduce TCO by eliminating network
support staff. If, however, the quality of network service suffers,
causing inconvenience to customers and resulting in business disruptions,
the act of minimizing TCO could actually be counterproductive, a situation
that has occurred more than once in the business world.

Since the adverse effects of reducing TCO might be felt outside the IT
organization, managers must embrace a holistic approach, considering the
potential effects of local TCO cuts on the entire enterprise. Also, it is
important to remember that any reductions in direct costs usually come at
the expense of increased indirect costs, such as customer self-service, or
downtime costs.

The challenge for most organizations is actually to use the TCO
methodology, not just once, but on a regular basis. Remember that the
primary goal should not be the reduction of expenses. The primary
goal should be to manage IT investment portfolios in a manner that
promotes growth, competitiveness, and return on capital for the core
business.

TCO Is Not Intuitive

TCO may reveal that a "common sense" approach is not the best solution for
the enterprise. For example, according to analyst Alan MacCormack, advocates of
open source software, such as Linux, claim that obviously it’s the best solution
because it’s basically free. But the price of the software itself is only part
of the TCO equation, perhaps less than ten percent of the total cost of
ownership.

TCO Can Send the Wrong Message

CIOs have long struggled with the status of their organizations as “cost
centers.” In a way, the cost-centric nature of TCO calculations reinforces
that image, with the possible result that instead of being congratulated
for computing the real costs of IT investments, CIOs might be criticized
for costing the enterprise even more than their CEOs had imagined. High
TCO figures could even prompt calls for increased IT outsourcing. To add
balance to the analysis, CIOs should insist on ROI calculations,
since ROI measures the tradeoff between IT costs and benefits.

Close Enough

Critics allege that the TCO concept is flawed because it cannot produce
precise costs. However, this objection overlooks the fact that determining
an exact TCO is not really the issue. The value in TCO comes from
discovering, as in the case cited above, that some technologies cost more
than previously thought. Does this mean that firms should eliminate these
technologies and the benefits derived from them? Not necessarily. It does
unquestionably mean that companies should learn how to provide the
same services more efficiently, effectively, and economically.

Step-by-Step Implementation

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Understanding and managing IT costs demand insight and energy in equal
measure – insight to identify the cost factors affecting particular IT
investments, and energy to collect and interpret the data necessary to
make sound business decisions. Here is a step-by-step process, using an IT
help desk as an illustration. The same illustration, however, can apply to
manufacturing and other areas as well. Determining TCO is not a simple
process, but it has demonstrated its value in a number of cases, as these
suggested steps are followed:

Step 1: Create a “Chart of Accounts” for Direct Costs. Identify
the direct costs associated with IT investments. These costs include:

• Hardware and Software Costs – Acquisition of
  computer systems, peripherals, memory and storage, network components,
  operating systems, applications, and facilities.
• Network, System, and Storage Management Costs – Network
  administration
  and maintenance, performance tuning and capacity planning, change
  management, information security, quality assurance, and business
  continuity.
• Training and Support Costs – Staff and customer
  training, help desk support, and vendor management.
• Application Development Costs – Application design,
  programming, testing, documentation, and systems analysis.
• Communications Costs – Leased lines, on-line access,
  remote access, WAN connections, Internet access, and Web site hosting.

Step 2: Create a Chart of Accounts for Indirect Costs. Identify
the indirect costs associated with IT investments. These costs
include costs of services provided by customers themselves, plus the costs
of planned or unplanned system or network outages. Indirect costs are
not only unbudgeted, they are frequently unrecognized. This is
particularly true with respect to customer contributions. Resourceful
customers may be performing functions that would otherwise be provided by
IT personnel. Regardless of their source, these services represent
costs to the organization, costs that must be quantified to compute
realistic TCO figures. The best way to capture these customer costs
is through dialogue with the customers themselves, whether in person or
through customer surveys. Relevant questions in the Help Desk example
include:

• When you (the customer) encounter an IT problem, do you typically
  report the problem to the help desk? If the answer is no, do you
  attempt to fix the problem yourself? Do you rely on a colleague (or
  colleagues) for help? Do you try to “work around” the
  problem? If the impact is not severe, do you ignore the problem?
• How do you learn about new applications? Do you take advantage of
  IT-sponsored training courses? Do you train yourself? If you
  train yourself, how much time do you spend?
• How do system and network outages typically affect your
  business? Can the impact be quantified in terms of lost revenue or
  lost productivity?
• How could existing IT services be improved?
• What new IT services should be offered?

Step 3: Isolate the Cost Factors Pertaining to a Particular
IT Component or Service. Once the entire spectrum of IT
costs has been itemized (steps 1 and 2) and a TCO target selected,
identify all the relevant cost factors, including all the accounts (from
the charts of accounts) that apply to the subject component or service.

To illustrate, consider the TCO of an IT help desk. While on the
surface the total cost might amount to the costs of personnel and PCs, a
closer inspection of the charts of accounts will reveal the contributions
of other significant cost elements. Examples of direct costs include:

• Staffing costs, including benefits and overhead
• Outsourced contracts
• Training costs for help desk staff
• Costs for any training or promotional material distributed or made
  available to help desk customers
• Office supplies
• Cost of help desk software and associated maintenance
• Network support services
• Depreciation or leasing fees of help desk hardware
• Facilities overhead, such as rent
• General management and administration

Examples of indirect costs include:

• The time expended by customers in resolving problems that might
  otherwise be handled more efficiently and economically by help desk
  personnel.
• The time expended by customers in training activities that might
  otherwise be conducted by help desk staffers.

Step 4: For Each Cost Factor, Quantify the Real Cost as it
Pertains to the Target TCO Component or Service. For
capital items, like PCs, there is normally a fixed cost. For
services, like network support, the cost is allocated on a prorated basis.
If, for example, the organization’s total cost for network support is
$100,000 USD per year and the help desk staff accounts for five percent of
the employees served by the network team, it is fair to assume that the
help desk cost of network support is five percent of $100,000, or $5,000.

This calculus is based on a “normal distribution” of network support
functions. If the help desk receives a disproportionate share of
services, either higher or lower than the organization average, the help
desk cost of network support must be adjusted accordingly.

Step 5: Compute the TCO. Continuing with
this example, compute the help desk TCO by summing the contributions of
all the individual help desk cost factors. For best results, develop
a “TCO Calculator” spreadsheet which can be used – and refined over time –
for future TCO computations.

Finally, as a precursor to any TCO reduction initiative, order the cost
factors from high and low and calculate the relative percentage of
contribution for each factor. Applying the logic of the Pareto
Principle, focus first on the highest contributing cost factors when
selecting candidates for TCO reduction.

Reducing TCO

Containing IT costs requires a methodical approach that examines all
aspects of program or system operation. The following steps may help in
reducing TCO:

Step 1: Centralize Operations. Identify opportunities
for centralizing IT operations. In the case of a distributed help
desk, for example, consolidating operations under one roof could result in
significant administrative savings.

Step 2: Standardize Operations. Simple
environments are easier and cheaper to maintain than complex environments.
Reducing the number of customer hardware and software options will lower
maintenance costs while improving overall service. In the case of a help
desk, for example, where multiple applications are used to record and
manage calls, standardizing on one call center package can reduce software
and maintenance costs and improve problem tracking and resolution.

Customer education is a key component of the standardization process,
both to explain the rationale behind standardizing, and to prevent
“complexity creep.” This latter phenomenon occurs over time as
customers install new and unsanctioned applications, inadvertently delete
system files, and otherwise compromise “standard” configurations.

Step 3: Outsource and Out-task. Unless an
organization can count network and system management among its “core
competencies,” it may want to consider outsourcing or, in its more
selective form, “out-tasking.” For a multifunction help desk, for example, it
might be prudent to outsource (actually, out-task) support for standard vendor
products, such as the Microsoft Office suite, while retaining support
responsibilities for local, proprietary applications.

When establishing an out-tasking relationship, make provisions for
transferring knowledge to local staff members, thus fully leveraging the
investment. In addition to reducing TCO, outsourcing and out-tasking
are often advocated by enterprise finance professionals since they tend to
render costs regular and predictable. On the other hand, it is important
to figure out the TCO of outsourcing, since there are inevitably less
obvious costs, sometimes significant ones..

Step 4: Buy Smart. Simplify and automate the
task of managing customers, networks, and systems by selecting and
standardizing on hardware and software products that are not only highly
functional, but reliable and robust as well. For a help desk, for
example, the enterprise might select state-of-the-art computer equipment,
permitting staffers to run (for purposes of problem diagnosis) any program
or application that their customers might invoke.

Step 5: Train Intensively. One of the most
expensive elements in any operation (IT or otherwise) is personnel, which
makes training a key element in any TCO reduction campaign. Effective
training may lead to decreased costs. Some network component
manufacturers, for example, produce dozens of separate software
revisions for their products each year. Without constant training,
network technicians (and others) cannot perform efficiently. This
condition may manifest itself in longer network outages, more frequent
service interruptions, decreased performance, and diminished service
levels – in other words, higher TCO. In the case of a help desk, the need
for training is both constant and compelling. It is a matter of spending
one dollar now to save two or three dollars later.

The Changing Nature of Costs

Before proceeding with any TCO analysis, it is important to remember that
costs change with time, with business, and with technology. Consider,
for example, the continued development of mobile computing. Remote work
initiatives are adding a new dimension to TCO, including:

• Less travel, possibly leading to enhanced productivity
• Reduced space requirements
• Lower employee turnover, resulting in less recruiting

Web-to-host computing offers additional benefits, diminishing the costs
associated with remote backup and data security. Broadband
technologies, such as cable modems, are eliminating transmission delays,
allowing stay-at-home workers to function with increased fluidity,
efficiency, and confidence.

Once quantified, these and other cost reduction elements can be factored
in proportion to their influence into TCO calculations. As a general rule,
TCO must be calculated both vertically and horizontally – in other words,
in terms of current costs, and in terms of how those costs may change over
time, as best that can be estimated.

Leveraging Vendor Awareness

Since IT customers (or prospective customers) very likely may employ
total cost of ownership as a criterion in selecting IT systems –
especially “commodity” items like PCs – IT vendors are endeavoring to
influence the choice by stressing how their products offer a low
TCO. While such claims are essentially self-serving and therefore
unreliable, it may be useful to examine the basis on which these vendors
proclaim their TCO savings. Vendor analysis, for example, may point to
factors that customers have failed to consider, in which case the
customers should incorporate those factors when performing their own TCO
calculations.

Web Links

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• Microsoft TCO calculator: http://www.datacentertcotool.com/

About the Author

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Kirk Woodward is a technical writer and project manager,
Mr. Woodward’s areas of expertise also include enterprise software,
hardware systems, and the use of Internet resources.

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