Total cost of ownership accounting optimizes long-term costs.
Steven McCabe (firstname.lastname@example.org) is senior manager with Deloitte. Kwasi Mitchell and Nathan Ives are managers with the firm.
A large regional utility forfeited significant operating revenues after it replaced pulverizers at several of its coal-fired power plants. Because the replacement pulverizers were sized to operate at 100-percent capacity during operations using the coal typically procured by the utility, upgraded plants had to be derated following a change to lower BTU-rated fuel.
If utility decision makers had used a total cost of ownership (TCO) framework, they could have avoided this situation. An operations and maintenance cost assessment would have revealed the operational effect of the fuel change, allowing the company to consider oversized pulverizers to accommodate lower-grade fuels and thereby maintain the power plant’s capacity.
A confluence of market, regulatory, and technical factors will drive sustained levels of capital investment across each segment in the utility value chain for the next 10 years. The ongoing credit crisis significantly increases both the cost of, and competition for, capital that will force numerous utilities to reevaluate near-term capital expenditures.1 During these unprecedented times, it’s increasingly important that utilities focus on reducing lifecycle expenditures, while executing capital projects and not narrowly focusing on short-term procurement gains. A near-term focus on acquisition costs can result in uninformed decision making that is misaligned with corporate goals, regulatory requirements and investor demands.
The implementation of the TCO method during a long-term capital project’s planning phase (see Figure 1) ensures asset-expenditure decisions are well informed and balanced with corporate, regulatory and investor demands. This method is a supply-chain management leading practice; providing a wide-ranging view of the costs associated with asset ownership. TCO classifies costs, direct or indirect, incurred throughout the acquisition, operation and maintenance, or retirement of an asset (see Figure 2). Traditionally, there has been little difficulty in identifying acquisition costs. In fact, acquisition costs (specifically purchase price) are frequently the sole basis for making purchasing decisions, while often accounting for less than half of total asset costs.2 Employing TCO to identify less obvious lifecycle costs aids in early identification of best-fit purchasing decisions and long-term cost savings across the project and ultimately the asset lifecycle.3
A cross-functional team of supply chain, operations, maintenance, engineering, finance, and project-management personnel should conduct the TCO analysis. The team works collaboratively to develop a comprehensive cost model for the asset to be installed during the project and provides estimates for each relevant cost category (see Figure 3). A distinct cost model is developed for each supplier and scenario under consideration while estimates are based upon historical data and detailed market analysis. After completing this detailed analysis, the team is capable of making well-informed purchasing recommendations, identifying areas for potential cost reductions, and quantifying the long-term value associated with their recommendations. Furthermore, cost model completion enables the team clearly to communicate the rationale behind specific purchasing decisions to key stakeholders so they understand the key elements that have been considered.
Employing this structured approach provides visibility to both near-term budget and long-term cost implications. Successful implementation of TCO and complimentary strategic sourcing leading practices can result in long-term savings of 10 to 20 percent.4 Most important, use of TCO improves communication of project risks and cost drivers, both internally and with external regulatory agencies and investors. Because of the decreased investor risk tolerance resulting from the current economic downturn, this increased transparency and clarity in decision making displays a focus on operational excellence that can result in favorable treatment from regulatory agencies and gain preferred access to capital.
Large Capital Projects
TCO applicability to large capital projects by project lifecycle phase can be demonstrated by exploring material and equipment cost drivers. Currently, numerous utilities employ practices in which large spend materials are procured during the project’s planning and design phase with a strong emphasis on acquisition cost and lead time. There’s moderate coordination of large spend materials resulting in some saving efficiencies. Frequently, moderate to low-spend items are purchased in an ad-hoc fashion throughout the remaining project phases with emphasis placed solely on delivery timing. This ordering just-in-time mentality detrimentally impacts the project budget by increasing expediting and handling costs. Additionally, it prevents the supply-chain organization from fully leveraging supplier contracts and developing an optimized procurement strategy across the entire suite of corporate capital projects.
In contrast, using the TCO method provides innovative opportunities for reducing the cost of asset ownership. During the planning and design phase, stringent adherence to material standardization codes maintains procurement leverage and minimizes project and corporate inventory levels for design materials, associated tools, and spare parts. Collaborative analysis between design engineers and supply-chain staff provides a detailed understanding of the impact that project-design decisions have on the overall project cost to the organization. For example, the analysis should include a simple comparison of the cost of using a different 100-hp motor for a specific project by quantifying the additional design time due to unfamiliarity with the motor, the inventory expenses for alternate replacement parts, and procurement costs associated with purchasing a previously unstocked SKU.
TCO analysis also may be extended to labor resources. Few utilities have an integrated approach to sourcing and utilizing contracted labor for each work stream. Typically, utilities develop sourcing agreements for specialized services such as vegetation management, but then contract engineering and field labor as needed during the procurement phase of the project. Again, this just-in-time approach poses significant budget and schedule risks as resources may not be available or may command a significant premium because of a tight regional labor market.
The TCO method may be used to frame a discussion on labor needs across key business units and the associated cost penalties of employing a just-in-time approach. In conjunction with precise planning and scheduling practices, contractor resource needs can be determined during a project’s feasibility or planning and design phases. Moving the discussion into these phases provides opportunities for leveraging resources across capital projects and entering negotiations with suppliers well before peak staffing periods. A comparison of labor expenses for contracted resources used on multiple projects instead of the traditional one-project-at-a-time approach provides the information required for a detailed resourcing discussion among engineering, operations, maintenance, finance, and supply-chain staffs. Additionally, applying the TCO model may uncover other innovative strategies including opportunities to fund worker cross training that increases competition, or creating an apprenticeship program with local technical and vocational colleges to increase labor supply. Depending on regional labor market economics, TCO reveals the long-term advantages such programs can have on decreasing labor costs while simultaneously increasing resource skill levels to improve capital project execution.
Undoubtedly, there are challenges associated with TCO implementation. With respect to the management of change, staffs must be trained (and rewarded for) overcoming the practice of only evaluating acquisition costs. These organizational changes likely will result in increased training expenses and require ardent support from senior executive leadership. Furthermore, long-term benefits realized by using this method are difficult to capture in an annual budget cycle, necessitating alternate governance protocols to monitor and report multi-year cost savings. For example, a project manager may face the decision between waiting an extra two months for the best-fit condensate pump-motor replacement to arrive or progress with a readily available, lower-cost alternative, knowing the long-term reliability of this component option is lower. Without a governance structure that rewards long-term benefits capture, the project manager may be penalized for selecting the best-fit replacement. There also will be challenges associated, including soft benefits or difficult-to-quantify costs within the analysis. Last, information systems must be in place to capture the data required to quantify indirect costs.
Utilities implementing a structured TCO approach for capital project decision making will be in a position to distinguish themselves from among their peers as effective stewards of allocated capital. The programmatic development and adoption of the TCO approach not only reduces long-term project costs, but also improves communications across departments and provides greater transparency into project cost drivers. These key benefits are achieved through an unwavering commitment to the required culture change and realizing the need for a highly skilled and trained supply-chain staff that communicates with design and work management personnel.
1. Jason Lehman “Moody’s: Gas, electric IOUs facing near-term borrowing challenges,” SNL Financial LC, Charlottesville, Jan. 16, 2009.
2. “Gartner Total Cost of Ownership,” http://amt.gartner.com/TCO/MoreAboutTCO.htm.
3. Frank A.G. den Butter, Kees A. Linse “Rethinking Procurement in the Era of Globalization,” MIT Sloan Management Review, Fall 2008.
4. Based upon prior project experience.