The Strengths and Weaknesses of TCO

Total cost of ownership (TCO) is a metric frequently used by companies when they evaluate technology – but companies often make the mistake of focusing on TCO when evaluating potential investments. Just as you wouldn’t choose a heart surgeon based on lowest cost, or an airline based on the lowest amount of maintenance, you shouldn’t decide on IT based on the lowest total cost of ownership. Instead, you should be examining both total costs and total benefits to make an educated decision about the solution that will provide the greatest positive impact on the corporate bottom line.

TCO is the total cost of owning a particular item over some time horizon, and includes both the acquisition cost and the total cost per year. In some cases, this total is averaged over a three or 5-year period to get a comparable estimate of ongoing expenses.

TCO’s Forte: Budgeting

The strength of TCO is in providing an understanding of future costs that may not be apparent when an item is initially purchased. However, because the metric focuses only on cost, companies that rely entirely on TCO end up following a strategy that minimizes expenditures rather than maximizing returns for the company. These companies may purchase the least costly application, but they rarely choose the application that provides the greatest impact on the bottom line.

In most cases, calculating total cost of ownership is a straightforward effort that can be applied to both technology and non-technology decisions. Nucleus recommends calculating TCO over at least a 3-year period to get a full understanding of the ongoing costs associated with an application. Costs include initial acquisition costs of software and hardware along with support and consulting costs in the pre-start period. Costs in later years include maintenance and upgrades along with user training and ongoing IT support.

The yearly TCO figure is an excellent indicator of the ongoing costs and is best used as a projection for budgeting purposes. Averaging the TCO over the time horizon provides a reasonable metric for comparing similar applications. However, average TCO doesn’t provide insight into the timing of the costs. A product with low acquisition costs and high maintenance is likely to be less attractive than one with higher acquisition and lower ongoing costs but may have a similar TCO over the period of analysis.

TCO’s Weaknesses

The problem with total cost of ownership is that, used alone, it provides a very narrow view of just the costs associated with an application. TCO completely ignores the benefits. Your objective should be not to choose the cheapest application, but to choose the application that provides the greatest benefit or return for the company. For example, you may be able to build a Web site using a part-time intern and Microsoft Front Page, but are you getting the greatest return you could achieve?

TCO also doesn’t help you prioritize projects. Prioritizing based on lowest cost would mean never investing in a project. Instead, companies need to weigh costs, benefits, and portfolio risk to determine which projects should come first.

There’s nothing wrong with financial discipline, and every company should have a clear understanding of the ongoing costs associated with every technology investment they make. Many companies and analysts have focused on TCO as an important metric primarily because it’s a tangible number: it’s easy to point to cost accounting and make a decision based on less expenditure. However, technology can have a dramatic impact on the bottom line. Looking beyond TCO to the full picture of costs and benefits ensures you purchase not the cheapest solution, but the best solution for your organization.