Carr, L. P. and C. D. Ittner. 1992. Measuring the cost of ownership. Journal of Cost Management (Fall): 42-51.
Summary by Corinne Rakocy
Master of Accountancy Program
University of South Florida, Summer 2003
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One of the problems with traditional cost accounting systems today is that only the purchase price from a supplier is traced to the cost of the purchase. In many cases, there are many other costs than the invoice costs like inspection, receiving, and ordering costs. All these other costs, instead of being tracked as part of the cost of ownership associated with the supplier, are just added to the list of expenses incurred by the purchasing company. Since these costs (repairing damaged parts, scrapping, returning items) are costs that are actually incurred because of supplier’s work quality, these costs should be factored into the costs associated with that particular supplier. This concept of using cost of ownership in determining the costs involved in using a specific supplier becomes particularly important since purchased materials consist of 70 percent of some manufacturing companies expenses. When so much of a company's costs depends on the quality and prices determined by an outside source, it is important to be able to properly track where these costs come from in order to minimize costs and maximize quality.
Some cost accounting systems today have addressed the issue of cost of ownership. These progressive systems are used in companies with JIT (Just-in-Time) inventory techniques and TQC (total quality control). These systems associate not only the invoiced price of the purchases to the supplier, but also the cost of purchasing, holding, poor quality, and delivery failure. Examples of these costs are freight, storage, insurance, scrap, warranties, rework, and lost sales due to late delivery. Sometimes these costs are so significant that they are greater than the purchase price. Texas Instruments did a study and found that in once case, the cost of ownership was over 180 times the invoiced purchase price of an item.
Manufacturers that use the cost of ownership concept track these costs through the Supplier Performance Rating System (SPRS). This system, developed in 1985, has opened the eyes of many manufacturers to the extra costs incurred by their companies due to the choice of supplier. In order for managers to choose suppliers based on total cost of ownership instead of just original purchase price, many companies have developed supplier rating systems or supplier performance indexes (SPI). Northrop uses a system that calculates all the extra, or nonconformance, costs using developed standard cost times standard hours to correct the problem, then adds these nonconformance costs to the purchase price and divides the sum by the purchase price.
SPI = Nonconformance Costs + Purchase Price
Northrop now uses the SPI created for a supplier as a multiplier to determine the cost of ownership incurred. For example, say the SPI for a supplier is 1.15 and the quoted price of an item for that supplier is $300. The cost of ownership for that item from that supplier would be 300 x 1.15 which gives a total cost of $345. Another Northrop supplier may have the same merchandise for a quoted price of $310 but this supplier has a SPI of 1.05. The cost of ownership of the same merchandise from the second supplier is only $325.50 instead of $345. By using a SPI, Northrop can determine that although the first supplier gives a lower quoted price for the merchandise, in the long run, the second supplier will create fewer costs for the company. Each company using a supplier performance index uses calculations that individually work with their company.
Although companies calculate SPIs in different ways, the results are the same, improved cost tracking. This improved cost tracking allows manufactures to better choose quality suppliers, which, in the end, gives the consumer a better quality item at a lower price. Supplier purchase indexes have also made suppliers look at their own quality system. Suppliers that lose business due to their SPI might reevaluate and improve their quality in order to regain the lost business and maybe gain more business because of the quality increase.
Other ownership cost systems focus not on the costs of problems with the merchandise purchase, but with the holding and ordering costs involved in the purchases. Electronic data interchange (EDI) systems help to reduce these costs. EDIs are systems that allow the supplier’s system to communicate with the manufacturer’s system in order to reduce invoice time and paper work. EDI systems are also very helpful with JIT inventory methods. By reducing invoice time with direct communication between systems, holding time for inventory can be reduced, therefore reducing storage costs.
The main benefit realized from the cost of ownership system is the communication between the suppliers and the purchasers. With better communication, both sides of the purchase agreement can lessen costs and improve quality. Through better communication, both the buyer and seller can determine the adjustments needed to lower cost of ownership. The cost of ownership cannot improve though without adjustments on both sides of the purchase agreement because the costs are dependent on both entities, not just one.
Although the cost of ownership approach can result in many benefits to the buyer and seller, there are some difficulties with the system. One problem is that some service values are hard to quantify. These services include R&D, personnel, facility, and product service capabilities. Because these capabilities are hard to value, some systems would leave them out of the calculation altogether, but that would not create an accurate system. When these cost estimates are included in the calculation, the evaluation must take care not to make bias estimations on the value.
Another problem could develop for suppliers that are not used very often. If the infrequently used supplier has one bad shipment, the SPI for that supplier could unfairly skyrocket. New suppliers are also a problem for the system. Since there is no historical data for the buyer to base SPI rates on, the new supplier is stuck with the average supplier rates until some data can be determined. This can put the new supplier at an unfair disadvantage.
A final problem is that performance measurement systems have not evolved with the supplier performance rating system. This means that although a company may be able to see that choosing a higher purchase price supplier may be the best in the long run, the low purchase price supplier might be chosen because the only performance measure used to evaluate the decision is based on the purchase price variance. Therefore, to obtain the benefits from the cost of ownership program, companies need to integrate this information into their performance measurement systems.