Total Cost of Ownership (TCO)

model for an IT system acquisition

Manojit Chattopadhyay
 Introduction
Total Cost of Ownership TCO for IT Assets and IT/IS
Acquisitions

How to Uncover the Hidden Costs of Ownership

What is the Total Cost of Ownership?

Total Cost of Ownership (TCO) is an analysis meant to
uncover all the lifetime costs that follow from owning
certain kinds of assets.

As a result, TCO is sometimes called life-cycle cost analysis.

 Importance of TCO analysis
• Asset ownership brings purchase costs, of course, but owning
also brings costs due to installing, deploying, using, upgrading,
and maintaining the same assets.
• These after-purchase costs can be substantial.
• Consequently, for many kinds of assets, TCO analysis finds a
significant difference between purchase price and total life-
cycle costs.
• And, the difference can be vast when ownership covers an
extended timespan.
• As a result, TCO analysis sends a powerful message to
corporate buyers, capital review groups, and asset managers

Consider TCO instead of the purchase price when

making purchase decisions!
• Competitors of IBM, for instance, used their own TCO results to argue that
IBM systems were overly expensive to own and operate.
• This kind of argument is possible because the five-year total cost of
ownership for substantial hardware and software systems—from any
vendor—can be five to ten times the hardware and software purchase
price.
• Today, TCO analysis supports purchase decisions for a wide range of
assets.
• These include especially items with significant maintenance and operating
costs across ownership life.
• The total cost of ownership is, therefore, at center stage when leaders face
purchase decisions for large IT systems
• As a result, TCO for these kinds of assets is a central focus in the following:
– Budgeting and planning
– Asset life-cycle management
– Prioritizing capital purchase proposals
– Evaluating capital project proposals
– Vendor selection
– Lease vs. buy decisions
 TCO Cost model computations
• How to calculate total cost of ownership TCO in 6 steps.
– Step 1. Describe the acquisition, define TCO lifespan.
– Step 2. Identify ownership cost category impacts.
– Step 3. Structure the total cost of ownership cost model.
– Step 4. Add Individual resources, activities to cost model.
– Step 5. Estimate cash inflows, outflows.
– Step 6. Summarize cash flow totals and financial metrics.
• Illustrating TCO: Example results and scenario comparisons.
• What can TCO analysis can tell you? And, what does TCO
reveal?
• Why is TCO analysis blind to most business benefits?. And
how does TCO find benefits for cost savings?
 Hidden Costs May Include:
• Acquisition costs: These can include many kinds of spending due to identifying, selecting, ordering,
receiving, inventorying, and purchasing. Any of these costs can signal the start of ownership life for
the analysis.
• Upgrade, Enhancement, Refurbishing costs.
• Reconfiguration costs.
• Setup and Deployment costs: Costs due to configuring space, transporting, installing, setting up,
integrating, and outside services.
• Operating costs: For example, expenses for human operator labor, or energy costs and fuel costs.
• Change management: costs: For example, expenses for user orientation, user training, and
workflow or process change.
• Infrastructure support costs: For example, the costs of heating, lighting, cooling, or IT support costs
due to asset acquisition.
• Environmental impact costs: For example, expenses for waste disposal, clean up, and pollution
control. These may also include charges for "environmental compliance" reporting.
• Insurance costs.
• Security costs:
– Physical security: For example, expenses for building locks, secure entry doors, closed-circuit television, and
security services.
– Electronic security: For example, the costs of security software, offsite data backup, and disaster recovery
services.
• Financing costs: For example, fees for loan interest and loan origination.
• Disposal / Decommission costs.
• Depreciation expense tax savings (a negative cost).
• The list of hidden cost categories above could, of course, extend further for many kinds of
acquisitions.
 Define one Cost Model Axis For Resources, One Axis for life-
cycle Stage

Acquisition Operating Change Costs

Cost model Costs Costs

Software Obvious cost Obvious cost Hidden cost

Hardware Obvious cost Obvious cost Hidden cost
Personnel Hidden cost Hidden cost Hidden cost
NW & Comm Hidden cost Hidden cost Hidden cost
Facilities Hidden cost Hidden cost Hidden cost

TCO cost model for an IT system acquisition. Rows are resource categories and
columns are IT life-cycle stages. The contents of each cell are individual resource
items.
Note that the vertical axis represents IT resource
categories while the horizontal axis represents IT life-cycle
stages.
The model design succeeds when it achieves two objectives:

• Firstly, each axis covers the complete set of cost classes for
one dimension: (1) Resources or (2) life-cycle stages.
• Each includes all categories on that dimension that are
useful to decision-makers and planners.
• Secondly, the cost categories (or classes) capture apparent
costs and also the less-obvious hidden costs.
The two axes, that is, should convey self-evident completeness.
If they do, there should be no unpleasant cost surprises later,
during implementation.
And, the analyst should never have to answer questions such as:
Why didn't you include this? Or that?
 Resource items in two cost model categories.
Acquisition /hardware costs Operating costs/personnel
2nd row, 1st column 3rd row, 2nd column
Server system purchase Administrative labor
PC system purchase • Systems operators
Engineering workstation purchase • Systems programmes
Storage space purchase • Application programmers
Other peripheral HW purchase • Network admin labor
• Storage manager
• IT manager
• Other admin
Troubleshooting labor
Continuing contract labor
Continuing training (professional)
Consider Two Possible Scenarios
1.Proposal: System Acquisition
2.Business as Usual
The "Business as Usual" scenario is an important part of any
TCO analysis.
It recognizes that owners will still spend money on many of the
same IT cost items, even without the new system.
As a result, the "Business as Usual" scenario, therefore, serves
as a basis for comparison.
In fact, the baseline provides the only way to measure cost
savings and avoided costs.
For this reason, the TCO analyst uses scenarios 1 and 2 to
construct a third scenario:
3.The Incremental Scenario.
This scenario shows the cost differences between corresponding
line items on "Scenario 1" and "Scenario 2."
 Illustrating Total Cost of Ownership
Example TCO Results and Scenario Comparisons

• Cost model categories for the cost model rows and

columns were chosen to represent cost areas that need
careful planning and control over a three year period.
• Once the scenario cash flow estimates exist (previous
section), the analyst can use the model to show cost
dynamics not easily seen in the cash flow statements.
• Here, the cost model cells in next three slides hold 3-
year totals for items in each cell.
• The figures that go into each sum, of course, come
from the cash flow statements.
 Proposal System Acquisition Scenario
Acquisit Operati Change % of
$ in 1,000s ion ng Costs Total TCO
Costs Costs
Software 444 121 220 785 5.5%
Hardware 874 222 122 1,218 8.5%
Personnel 188 5,699 3,925 9,812 68.8%
NW & Comm 255 1,082 892 2,229 15.6%
Facilities 60 46 106 212 1.5%
Total 1,821 7,170 5,264 14,256 —
% of TCO 12.8% 50.3% 36.9% — 100.0%
Three-year cost estimates for the Proposal scenario.
 Business as Usual Scenario

Acquisiti Operatin Change % of

$ in 1,000s Total
on Costs g Costs Costs TCO
Software 274 82 138 494 2.9%
Hardware 539 97 71 707 4.1%
Personnel 55 8,873 5,952 14,879 86.2%
NW & Comm 146 543 459 1,149 6.7%
Facilities 0 15 15 29 0.2%
Total 1,104 9,610 6,634 17,258 —
% of TCO 5.9% 55.7% 38.4% — 100.0%

Three-year cost estimates for the "Business as Usual" scenario.

 Incremental Cash Flow (Proposal Less Business as
Usual)

Acquisition Operating Change Costs

$ in 1,000s
Costs Costs
Software 170 38 83
Hardware 335 125 51
Personnel 133 (3174) (2027)
NW Comm 109 539 432
Facilities 60 31 91

Total incremental costs for each cell of the cost model.

Each cell represents the value from a cell in Exhibit 6A, less the
corresponding cell value in Exhibit 6B. Negative incremental values
in parentheses indicate cost savings under the "Proposal"
scenario.
 The analysis in these three tables provides a wealth of useful
information that management can put to good use, regardless
of which scenario they choose to implement.

• What Can TCO Reveal?

• What Does Total Cost of Ownership Analysis Tell
You?
 TCO Analysis Can Uncover "Hidden" Costs of
Ownership
• TCO can bring out so-called "hidden" costs of ownership.
• In this example, owners chose to include all the essential
costs from system acquisition, including labor costs for people
who use or support the systems.
• When deciding whether or not to acquire a new system, it is
easy to focus excessively on hardware and software costs.
• Managers should focus instead, however, on the Personnel
costs that come with the system.
• These "People costs" are 68.8% of the TCO.
• As a result, how the firm trains, employs, and manages these
employees will ultimately play a more significant role in
determining the actual cost of ownership than other factors,
such as the choice of HW or SW vendor.
 Potential Problem Alerts
• TCO can help spotlight potential cost problems before they become
real problems.
• In the IT world, for instance, change costs can often exceed forecast
and budget.
• These typically include expenses for upgrading, adding capacity,
reconfiguring, adding users, migrating to different platforms, and so
on.
• All of the change cost items in this model could appear instead
under either of two cost column headings, Acquisition or Operating
costs.
• Here, however, the analysts chose to focus on change costs by
giving them a Change cost column of their own.
• As a result, it is easier to measure, plan, and control expenses
specifically due to change.
• Note especially in this example, change costs represent between 35
and 40% of total cost of ownership in both scenarios.
 Identify Cost Savings and Avoided Costs
• An Incremental Cash Flow Statement Finds Cost
Savings and Avoided Costs.
• In this example, Proposal Scenario costs are more
substantial than Business as Usual Costs in almost all
cells of the cost model.
• "Business as Usual" costs are higher in only two cells:
Personnel Operational Costs and Personnel Change
Costs.
• Here, however, the Proposal Cost Savings show up as
substantial negative numbers in the incremental cost
model summary.
• Those two cost savings are more than enough to give
the Proposal Scenario a considerable TCO advantage.
 TCO is Blind to Business Benefits
Except For Cost Savings and Avoided Costs

• TCO analysis is not a complete cost-benefit analysis

because TCO tries to uncover ownership costs, but it is
blind to other kinds of business benefits due to
acquisitions, projects, or initiatives.
• Since TCO sees only costs, it takes no account of benefits
such as higher sales revenues, faster information access,
greater operational capability, competitive gains, or higher
product quality.
• As a result, when TCO is the primary focus in decision
support, decision-makers are assuming the following:
• Benefits other than cost savings are more or less the same
for all options.
• And, the options differ only in cost.
 Conclusion

• When the owner believes different solutions may bring

different business benefits, a complete cost-benefit
business case analysis may be appropriate.
• In brief, TCO analysis can find only two kinds of
business benefits: cost savings and avoided costs.
• Either of these benefits can show up when comparing
TCO for different scenarios.
• The example above shows, for instance, that when TCO
is less under a "Proposal" scenario and greater under a
"Business as Usual" scenario, the results are cost
savings under the "Proposal" scenario.
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