Total Cost of Ownership: Cost Versus ValueBy Philippe Fournet-Fayard | Tue, 01/12/2021 - 17:18
Every business leader or salesperson has been faced with this unbelievable customer decision regarding industrial investment: Take the cheapest offer despite evident differences in technology and its operational costs.
What is behind the decision, what are the consequences of such a decision? What should we change? Why is it a real concern in the health industry, and especially in the biopharma industry?
The total cost of ownership (TCO) is used to calculate the total cost of purchasing and operating a technology product or service over its useful life. These three underlined phrases are the basis of the analysis necessary to support the right decision.
When an industrial company decides to invest, there are normally three basic possible reasons for it:
grow the business
answer customer concerns
Despite the motivation, the pharmaceutical industry acts as a long-term investor. Any industrial project is based on 20-plus years of operating the facility. As a result, it makes a great deal of sense to take special care regarding the costs linked to these 20-plus years of operation. This is unlike the case of the micro-electronics industry, for example, where investment has a three- to five-year lifetime, providing a different perspective on the subject.
We are all used to handling operating costs. Most are identified and direct; some are not always considered. For example, in our health industry, to intervene in a critical system requires requalifying and validating the system, to the extent required by the facility documents. Any additional intervention for maintenance on the systems would cost time and effort to revalidate it, on top of costs related to the lack of production and spare parts.
Let me use a typical situation we face in the pharmaceutical industry: the definition of air filters for an HVAC system. The table below compares two filters. The have the same nominal airflow and same efficiency but different sizes and different costs of acquisition.
Looking deeper into the specifications of each filter, we can see a different initial pressure drop but the same final max recommended pressure drop. This means that from the very first day, the cheapest filter will consume 40 percent more energy and will incur a 20 percent reduction in life time. The life-time reduction will oblige the maintenance team to change the filters five times instead of four times for the other filter. The collateral cost of an additional shutdown of a critical system is much higher by itself than the cost of the filters we will change. Typically, the price difference between these two filters is around 15 percent. Do the math! The right calculation is the Annual Total Filtration Cost, including the Complete Shutdown Cost, not the cost of the filters.
Another aspect of the dilemma related to Investment cost/Operating cost is the accounting treatment of both cases. The investment cost in the biopharma industry is treated as a fixed asset and typically depreciates over a long period of time (several decades). As a result, the impact of a 10 percent higher price on a purchasing decision has very little impact on the cost of the product itself. On the contrary, the operational expenses have a direct and immediate impact on the production costs, and consequently on the cost of the product and its sales price on the market, or the margin the market will allow you to get. This is key to understanding where to put extra money.
The TCO is important for evaluating technology costs that are not always reflected in upfront pricing. Industries that invest for a long period of time in operations (like biopharma) gain a huge benefit by focusing on total cost, including purchasing and operation. Yes, this is more complicated to calculate than just the acquisition price, but it may make the difference on the indirect part of the product manufacturing cost.
Motivating the organization to adapt the TCO analysis before deciding is the key. And it may begin with changing the bonus calculation of the purchasing department: no more reward only for the savings on the acquisition price. This approach is still a cultural challenge in many companies.