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CHAPTER 6
TOTAL COST OF OWNERSHIP (TCO)
provided, this table does contain one element that requires elaboration, i.e.,
the inventory carrying charge. Although they are usually not easy to articulate,
inventory carrying charges can occur at any part of a supply chain where
inventory is present. Until the final customer purchases an item, someone
has to retain title to goods and therefore accrue carrying charges. Within the
international arena this issue is important because the material pipelines are
much longer in terms of time and distance. Most companies disregard these
charges because they don’t seem real or are too hard to quantify.
While different sources will disagree on the specifics, inventory carrying costs are
generally comprised of three categories. The first category is the cost of capital.
Inventory consumes working capital that could have been put to other productive
uses. Some companies may also view this component as an opportunity cost.
The second category reflects the cost of storage. Inventory storage can include
insurance, heat, lighting, rent and cycle counting. The final category includes
the combined costs of obsolescence, deterioration and loss. Factors such as
expired shelf life, scrap and theft can all be part of this category.
If all goes well, finance is able to quantify these components and arrive at a
carrying charge that is expressed as a percent of the inventory’s unit cost. For
example, a piece of inventory with a unit price, whether it is a raw material, work
in progress, or finished good worth $10 with an assigned carrying charge of
25%, results in an annual carrying charge of $2.50 per unit. Inventory held less
than a year is prorated accordingly. Companies that are interested in managing
carrying charges as a cost element pay particular attention to a set of measures
that report inventory turns.
In the Chefs Supply example, the company incurs carrying charges prior to
production when the dried fruit is held in storage for a month. This example does
not include carrying charges when the dried fruit is in transit from Madagascar
because title (i.e., ownership) does not transfer to Chefs Supply until the goods
arrive at the South African port. It is possible to engage in a lively debate about
whether in-transit carrying charges should be part of the total landed cost model
when the buyer does not own the inventory. The model developed here only
includes charges that are directly incurred by the buyer.
How exactly is the carrying charge determined? In this example, the buyer
imports a container of dried fruit each month and then expects to hold that
container for one month in a warehouse. This is the equivalent of holding one
container in storage for a year. So, one container of dried fruit is valued at
$11 600 (40 000 kg multiplied by $0.29 unit price per kilogram). Next, the 24%
carrying charge is applied against $11 600 to arrive at an annual carrying charge
of $2 784. Because this is an annual charge it is divided by the annual demand
to arrive at a relatively insignificant charge of $0.006 per kg.
This analysis shows how total supply chain costs can be allocated to provide a
more complete picture of total supply chain costs. After completing this analysis
it becomes possible to compare supplier costs across common cost categories,