Picture this: you’re walking down the aisle and you spot the thing you’re looking to buy, but there are two options to pick from.
You look at the sticker price for both and opt for the cheaper option, confident in your choice to save money.
But a month down the line, the option you picked starts having problems and requires a repair. Then a part breaks, and now you have to pay for a replacement. And later down the line, it’s not running as smoothly, leaving you to consider replacing it altogether.
These types of procurement decisions with long-term impacts happen in business all the time, except they apply to more than a simple either-or choice while shopping. With investment decisions that have long-term implications, you can’t look at the purchase price alone.
This is where the total cost of ownership comes in. And if you master the calculation, you’ll be empowered to make decisions that benefit the business in the long-run rather than chase short-term savings.
What is total cost of ownership (TCO)?
Total cost of ownership (TCO) is a financial metric that measures all direct and indirect expenses incurred in acquiring, operating, and maintaining a product, service, or system throughout its entire lifespan.
Every product, service, or system has a purchasing price. However, what you purchase may also require maintenance, updates, repairs, or other additional costs that require more investment from the business.
This is where TCO comes in. This metric accounts for all of the costs to show the complete financial commitment of a business investment. By looking at the TCO of something, you can understand the difference in long-term costs, not short-term affordability.
Components of TCO
Total cost of ownership can be broken down into six individual components:
- Acquisition costs include the initial purchase price, taxes, shipping, and additional fees involved in acquiring an asset.
- Implementation and setup costs are the expenses involved in getting an asset integrated and operational, including installation, configuration, and modification costs.
- Training and support costs are induced by employee education and onboarding costs, any assistance required to ensure the asset is being used efficiently and effectively.
- Operational costs are day-to-day expenses induced by the asset, like energy consumption, maintenance costs, or staff upkeep.
- Downtime costs represent the cost of an asset being unavailable for use, resulting in lost productivity or revenue opportunities.
- Disposal costs or resale value occur at the end of an asset’s lifecycle, including the cost of decommissioning or any income from resale value.
These six components encompass any financial impacts from an asset over its lifecycle. When tallied all together, you get the total cost of ownership with all expenses considered.
Is TCO the same as ROI?
TCO and ROI (return on investment) are different, but related, financial concepts used in purchasing decisions and asset acquisition.
TCO is solely focused on the costs of a purchase. It captures every expense associated with an asset over its lifespan.
You use TCO when you want to answer the question “How much will this cost us over time?”
ROI is focused on the financial return of an investment based on its costs. The basic ROI formula is:
You use ROI when you want to answer the question “How much do we benefit for every dollar spent?”
Where the two are connected is in the ROI formula. It’s best to use TCO as the cost of investment, as it’s the most accurate measure of the true cost of an asset.
Consider a purchase that will generate $200,000 in financial benefit. There are two options being considered, one at an initial purchase price of $50,000 and the other at $100,000. Comparing ROIs, that’s an ROI of 3.0 versus an ROI of 2.0.
But if the $50,000 option requires an additional $100,000 in costs over its lifecycle, totalling $150,000, and the $100,000 option only requires $25,000, totalling $125,000, that’s now an ROI of 0.33 and 0.60, respectively.
When using the TCO of the assets, the purchase with a higher initial price point has a better ROI over its lifecycle.
Why TCO is important for businesses
Understanding the total cost of ownership of an asset impacts how businesses approach decision-making, financial planning, and forecasting. Here’s how.
Holistic decision-making
It’s natural to look at the sticker price of something when making a purchase decision. Holistic decision-making looks beyond the initial price, considering long-term, interconnected impacts to protect yourself from future costs.
Instead of opting for something that saves money in the short term, TCO helps you make decisions based on how costly the entire lifecycle of an asset is. The result: making the best decision for the long-term efficiency of the business.
Risk management and mitigation
Using TCO in your decision-making doesn’t mean you’ll always opt for the safer option. Ultimately, every business has its own risk tolerance, and some may opt for short-term savings even if there’s long-term risk.
However, that long-term risk doesn’t need to be taken on without protection or planning.
Mapping out the lifecycle of an asset helps you identify the potential risks over the entire time of ownership. If you opt for the choice that has the risk of future costs, you can prepare cash reserves and contingency plans to minimize the impact.
Improved budgeting
By understanding the upcoming costs incurred by asset ownership, finance teams can incorporate them into their budgets and financial planning.
For example, you may be looking at a specific piece of equipment that requires annual inspection and maintenance. Knowing this, financial forecasts and budgets can add that into their projections, keeping the business prepared.
You don’t need pinpoint precision when predicting upcoming costs, but even an estimate helps businesses avoid cash shortages and overoptimistic forecasts.
Accurate ROI calculations
If you calculate the ROI of an asset on just the purchase price, you could be overestimating how valuable the acquisition was. But if you calculate ROI using the TCO of an asset, you get a more accurate representation of its value proportional to all of the costs.
An asset that generates $100,000 on a $20,000 purchase has an ROI of 4. If that asset has another $5,000 in additional costs over its lifecycle, the ROI drops to 3.
When comparing investments, calculating the ROI based on the TCO helps you make the best, most accurately informed decisions.
How total cost of ownership works
The calculation of the total cost of ownership for an asset is straightforward. But the process of getting there is more complex.
Total cost of ownership formula
The formula for calculating TCO is:
Calculating TCO is as easy as adding these numbers together. The difficult part is finding the numbers themselves.
What’s included in the TCO calculation
To calculate the TCO of an asset, you need to understand every expense category that’s tied to it.
If you were to calculate the TCO of software, you’d likely focus on licensing, integration, and training costs. But if you were to calculate the TCO of equipment, you’d consider energy utilization, repair, and maintenance costs.
When performing a TCO calculation, start by listing out all of the potential costs associated with the asset.
You also need to consider the time horizon of the asset. The longer that an asset will be used within the business, the longer the time horizon used in the TCO calculation.
Choose a timeframe that lines up with your asset replacement cycle or strategic planning period. For example, you would use a time horizon of five years if you plan on replacing the asset in that timeframe, or if your strategic planning is looking that far ahead.
With the costs and the time horizon, you can start the process of estimating and calculating the associated costs over the lifecycle of the asset.
The role of TCO in budgeting and forecasting
All of the work you put into a TCO calculation strengthens your budgeting and forecasting processes.
Every cost you’ve mapped out over the lifecycle of the product can be input directly into a budget or forecast. These are costs finance teams may otherwise miss in their cost projections.
Ultimately, you’re giving everyone transparency into the long-term financial commitments of procuring an asset. Looking beyond the one-time purchase price gives stakeholders the clearest picture of the money needed in an investment, and over what timeframe that cash is committed.
What types of costs should be considered in a TCO calculation?
The six components of a TCO calculation are:
- Acquisition costs
- Implementation and setup costs
- Training and support costs
- Operational costs
- Downtime costs
- Disposal costs or resale value
To add some depth, these components can be further broken down into other considerations.
Direct vs indirect costs
The costs included in a TCO calculation will fall into one of two categories: direct and indirect costs.
Direct costs are the easiest to consider as they are directly traceable to the specific asset. Examples of direct costs include purchase price, shipping, installation, and training.
Indirect costs are harder to quantify as they aren’t as easily tied to the specific asset. Examples of indirect costs include productivity impacts, downtime, and opportunity costs.
Let’s break this down with an example.
A business is purchasing a new CRM suite that will take a full week to properly implement. As part of the TCO calculation, they map out the direct costs and indirect costs.
The direct costs would include the cost of the software, training resources, and any costs of implementation.
The indirect costs include the diversion of IT from existing projects to tackle the implementation, the loss of productivity from the sales team getting up to speed on a new platform, and the opportunity cost of dedicating time to training sessions.
Direct costs and indirect costs are equally important to consider in a TCO calculation, even if one is more easily associated with an asset than the other.
Hidden costs
Hidden costs are the frequently overlooked expense types missed in a TCO calculation. And if you overlook these costs, you’ll underestimate the true cost of an asset.
Examples of hidden costs include:
- Compatibility and integration costs: You may find out that an existing component of your business is incompatible with the new asset, requiring another purchase and incurring additional costs.
- Customization costs: Some assets aren’t “out of the box” solutions that require time and effort to tailor to your specific processes. Over this time, operations likely won’t be at their maximum efficiency.
- Change management: It takes an organizational effort to drive adoption and get everyone on the same page.
- Upgrade and evolution costs: As technology and business needs change, what might be a modern solution today becomes outdated and in need of replacement.
- Opportunity costs: When you choose one option, you lose out on the opportunity of using the committed capital and assets elsewhere. Dedicating money and staff to asset acquisition prevents it from being used in another part of the business.
Recurring vs one-time costs
Separating costs into recurring and one-time expenses helps you plan for their cash flow impacts down the line, or potentially identify cost reduction opportunities.
One-time costs, like purchase price and implementation costs, have an immediate impact but won’t continue in perpetuity.
Recurring costs like subscriptions, maintenance, or licensing accumulate continuously throughout the asset’s lifecycle.
It’s not uncommon for recurring costs to meet or exceed the one-time costs. Higher one-time costs are an easier pill to swallow than higher recurring costs that will continue to impact the business over time.
This is also something to consider when comparing a one-time purchase versus a subscription model, like a one-time, perpetual license for a software versus the subscription model. Compare both over the lifecycle, and you may be surprised which comes out as most cost-effective.
Common TCO mistakes
As straightforward as the TCO formula and calculation seem at first glance, there are still potential mistakes that can trip up even the most experienced finance professionals.
Overlooking hidden costs
The name “hidden costs” isn’t misleading; they are difficult to identify and map out over the lifecycle of an asset. And even if you can identify them in the short term, more may be uncovered over the long term.
Start with a comprehensive list of potential costs and disruptions. To try and cover everything, consult with other members of the organization who may have a different perspective on the impacts of an asset.
Using unrealistic assumptions
Having unrealistic assumptions about the costs of an asset distorts TCO calculations. You may underestimate the downtime incurred by a switch, be overoptimistic about adoption, or assume perfect productivity from day one. Any of these errors will affect the TCO calculation.
Try to incorporate historical data or outside perspectives to test your own assumptions. For example, customer reviews might highlight a cost factor you otherwise didn’t consider.
Ignoring the time value of money
The time value of money outlines how a dollar today is worth more than a dollar in the future. This is in part because of inflation and the ability to immediately use a dollar today to generate value.
Consider two assets with a TCO of $100,000. One asset has $75,000 in costs in year one, with $25,000 in costs in year five. The other asset has $25,000 in costs in year one, with $75,000 in costs in year five.
While both have a TCO of $100,000, the second asset allows the business to keep more of its capital to use over a five-year period, creating additional value.
If you’re using long time horizons in your TCO calculation, you need to “discount” future expenses to reflect the present value. Read our guide on discount rates to learn more.
Comparing assets with different lifespans
When comparing options, you may assume the same lifespan for both. But if one asset is durable, lasting ten years, while the other is flimsy and will degrade in five, you effectively need to purchase the second option twice for the same time of use.
The cheaper option may seem more appealing in the short-term, until you consider the potential need to replace it sooner than the alternative.
Using static TCO calculations
You set assumptions to complete a TCO calculation at the beginning of an asset’s lifecycle. These assumptions aren’t likely to hold over the entire lifecycle.
Software license costs may increase, an accident may incur repair costs, or employees may need certifications otherwise unaccounted for. If any of these unexpected costs or disruptions occur, you need to update your TCO calculation.
What purchases benefit from a TCO analysis?
It’s beneficial to think about the TCO of any purchase, but you certainly don’t need to break out the spreadsheets and calculators when comparing printing paper. However, these acquisition types most benefit from TCO analysis.
High-value assets and major capital investments
High-value purchases have high financial stakes that require a thorough TCO analysis for the most accurate decision-making. Examples like manufacturing equipment or enterprise software systems have high costs, long lifecycles, and long-term maintenance to consider.
A flawed decision with high-value assets has long-term impacts, including financial burdens and operational challenges.
It’s best to conduct a TCO analysis early in the procurement process so these considerations are included in the decision-making process from the get-go.
Technological purchases and upgrades
New technologies typically come with recurring costs in the form of licenses, infrastructure, training, updates, and maintenance. Plus, given how rapidly technology evolves, you need to think about the lifespan and replacement costs of a new technology solution.
Plus, technology relies on integrations to operate at peak efficiency. If something doesn’t integrate with your existing solutions, you’re looking at a larger overhaul (with associated costs) that you may not have planned for.
Long-term service contracts
It’s always a good idea to do a TCO calculation before locking yourself into a long-term service agreement or contract, even if a tangible asset isn’t involved. This includes professional services, outsourced labor, or suppliers of raw materials. In each of these cases, costs go beyond the initial signing.
There will typically be explicit monthly or annual costs that are easily considered. But also think about transition costs, potential price changes (if allowed in the contract), and training or implementation timelines.
The more that you put into a TCO calculation, the more confident you’ll be in signing that long-term contract.
An example of a total cost of ownership comparison
To illustrate how TCO impacts decision-making, let’s look at an example of a business considering two different software providers: a cloud-based solution and an on-premise solution. The business is assuming that this upgrade will have a lifecycle of five years.
Option A: cloud-based solution
- Initial subscription price of $15,000 per year
- One-time implementation cost of $25,000
- One-time training cost of $8,000
- Ongoing customer support costs of $5,000 per year
- One-time cost of updating existing systems totalling $10,000
- Estimated productivity loss throughout the transition of $7,000
We can breakdown the TCO calculation into each of the five years:
- Year 1: $15,000 + $25,000 + $8,000 + $5,000 + $10,000 + $7,000 = $70,000
- Year 2: $15,000 + $5,000 = $20,000
- Year 3: $15,000 + $5,000 = $20,000
- Year 4: $15,000 + $5,000 = $20,000
- Year 5: $15,000 + $5,000 = $20,000
- Total TCO: $150,000
Option B: on-premise solution
- One-time software license cost of $60,000
- One-time server upgrade of $20,000
- One-time implementation costs of $30,000
- One-time training costs of $10,000
- Annual maintenance and update costs of $8,000 per year
- Annual IT staff time costs of $12,000 per year
- Energy and hosting costs of $3,000 per year
- Projected infrastructure upgrade costs in year 3 of $15,000
Doing the same yearly breakdown over the five year lifecycle:
- Year 1: $60,000 + $20,000 + $30,000 + $10,000 + $8,000 + $12,000 + $3,000 = $143,000
- Year 2: $8,000 + $12,000 + $3,000 = $23,000
- Year 3: $8,000 + $12,000 + $3,000 + $15,000 = $38,000
- Year 4: $8,000 + $12,000 + $3,000 = $23,000
- Year 5: $8,000 + $12,000 + $3,000 = $23,000
- Total TCO: $250,000
Five years of subscribing to option A, the cloud-based solution, would total $75,000 while the one-time license cost of option B, the on-premise solution, is $60,000. On these numbers alone, the business would opt for option B.
But when you include all other costs and considerations, the maintenance and upkeep of option B make it far more expensive over the five-year lifecycle. The business would end up paying $250,000 for the on-premise solution versus $150,000 for the cloud-based solution.
This is why TCO is important. If you look simply at the explicit acquisition costs, you may be locking yourself into a decision that’s more costly in the long run.
Software that reduces your TCO with automation and integrations
Your finance team is doing menial, repeatable tasks every day. Whether it’s processing invoices, approving expenses, or simply structuring reports, this manual labor drives up the TCO of your existing tech stack.
But with BILL, you get seamless integrations with top accounting software and time-saving automations that cut out the manual labor, allowing finance teams to focus on the work that drives real value for businesses. Plus, you could save money on headcount with a smaller team doing the same amount of work.
We also offer a wide-range of payment options with competitive processing fees for both accounts payable and receivable, reduce costly data-entry errors, minimize security risks from fraud, and help you reduce maverick spend with cost controls.
Learn more about BILL and our AI-powered financial operations platform, or request a demo to see it in action.
