Exploring total cost of MRO

by Dr. Robert A. Kemp

Total cost of ownership (TCO) is a detailed process aimed at specifically identifying all cost drivers along with their contribution of cost to the project so that costs can be controlled, reduced and even eliminated.

MRO is a great place to apply the TCO concept. A quick example drives home this point.

Company A has total annual sales of $100 million. Of its total materials spend of $50 million, 80 percent ($40 million) is for direct materials and 20 percent ($10 million) is for MRO/indirect materials. If all other costs for Company A are $45 million, its net profit is $5 million (5 percent of total sales dollars).

If you capture a 10 percent reduction in the MRO/indirect spend, that figure decreases by $1 million to a spend of $9 million. Accomplishing that increases net profit 20 percent to $6 million. That’s substantial growth!

Asset management rules
Here are five rules for asset management to get us started.

RULE 1: All assets shouldn’t be managed the same way. We obviously want to manage high-value items differently than low-value items, but that doesn’t mean that we avoid managing the low-value items. The costs of the management process shouldn’t exceed expected benefits.

RULE 2: Five concepts/processes fit all assets.
• Supply management always leads acquisition.
• Allocation is always direct, in correct amounts and just in time.
• Utilization is always the right way and right rates, etc.
• Maintenance is scheduled, controlled and done correctly.
• Disposal is timely, done correctly and for the highest possible value.

RULE 3: Here are four concepts to manage old assets.
• Find it and identify it for reuse, scrap or sale.
• Use it again in its intended form.
• Create a new use for it through rebuilding or re-engineering.
• Employ it outside the firm by sale or gift to create full value.

RULE 4: You aren’t alone in this process. Other players exist to make a buck and they can help you with all aspects of asset management.

Scrap and junk dealers exist to move assets. Regional and national integrators, brokers and other dealers exist to improve acquisition, allocation, utilization, maintenance and disposal processes. On-line auctions support the entire process.

RULE 5: Improved asset management creates bottom-line benefits to make you a hero.
• Reuse generates the highest value to your operations.
• Reduced inventories create cash for better utilization and value.
• Sale or gift of excess/obsolete assets generates cash.

The true meaning of TCO
What does the total cost concept really mean? First and foremost, it doesn’t mean price. A supplier’s price is just part of total cost. It may be a small part. Simply put, TCO means a detailed calculation of all costs for an item or process. This model demonstrates a variety of costs that add to total cost.

Total cost = PR + FT + PK + SS + SM + QC + CC + CA + IV + OH + LC + BF + TT + IN + DW + PF + DF + CF

Where:
PR = The supplier’s product price
FT = Total freight costs
PK = Packaging costs
SS = Source selection costs
SM = Source management costs
QC = Quality control costs
CC = Communication costs
CA = Contract administration costs
IV = Inventory costs
OH = Overhead costs
LC = Life cycle costs
BF = Broker or agent fees
TT = Taxes, tariffs or other fees
IN = Insurance
DW = Disposal and waste costs
PF = Your established profit levels
DF = Documentation fees
CF = Currency fluctuations

Each of these items includes more than one cost driver. For example, PR (the supplier’s price) includes the supplier’s costs and its profit. If you let the supplier ship the product, PR would include the freight costs and perhaps a handling fee. Inventory costs typically include several things that are not always the same across firms.

Three points are important here. First, you must know and identify these costs and the drivers that generate them. Second, your budgets and cost accounting procedures must generate, track and provide data to manage the costs. These costs are often buried in other budget lines. Third, your supply managers must possess the skill sets needed to identify and calculate the costs and be able to effectively work with suppliers to build programs that control and reduce the costs.

Applying total cost management to MRO is worth the effort. My next article will explore the cost drivers in more detail and set the stage for subsequent articles on practical examples of success.

Robert Kemp is a consultant, speaker and the former president of the Institute for Supply Management. He can be reached at kempr@mchsi.com.

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