Counterpoint: The Fallacy of TCO Analysis in Making Printing Equipment Investment Decisions
Editor's Note: This article submitted by Bob Lindgren and Gerry Michael was written in response to the article titled, "TCO Considerations Before Acquiring a Digital Press," which was authored by Howie Fenton and recently published by Printing Impressions.
Graphic Arts firms often face very challenging decisions, and the fact that the vast majority are smaller companies, and privately held, places real restraints on the amount of capital they have to invest. In addition, the very nature of their industry means that they are often faced with complex options. These are just two of the reasons that for more than three decades, we have worked hard to help firms in the industry become better managed organizations, with a real understanding of the key decisions that managers and owners face on a regular basis. And these are also just two of the reasons that we must take issue with the recent article by Howie Fenton on Total Cost of Ownership, or TCO.
TCO is a tool specifically developed to help companies compare the total costs of alternative investments in information systems, where the trade-off is between costs, and the information that is processed. It was not developed to support decisions in production equipment, or for that matter, any investment which is expected to generate revenues or reduce costs. This type of analysis, generally referred to as “Capital Budgeting,” is well developed, and a number of very effective tools exist to assist management.
We have both written and spoken on this issue a number of times over the years, and actively advised many clients on how to evaluate these decisions. And even though TCO raises important questions that need to be addressed in all such decisions, it is not one of those methods by itself.
Let’s look at some of the issues that we feel make TCO a very limited tool, and not one that should be used in the manner that was put forward in Howie Fenton's article. Fenton contends that TCO would enable the firm to avoid these problems:
- Incorrect assumptions about price competitiveness on bids of high-volume work.
- Mistakenly believing that outsourcing services will save money.
- Calculations about profitability that don’t match year-end closings.
There’s no doubt that this would be a useful result if it could be achieved, but to test it, let’s look at how TCO works. Basically, Fenton explains that TCO quantifies the total cost of owning and operating a piece of equipment over its lifecycle, including operator wages, materials, service and click charges, capital cost and an allocated share of overhead. Simply put, TCO is a Budget Hour Rate (BHR) plus materials.
Given this, let’s examine how TCO would address the identified problems:
The first is price competitiveness. Whether we like it or not, the price that can be obtained for a particular job is determined by the buyer, since they will write the check. No matter how much we would like them to, they will not pay more for the job than it’s worth to them or they perceive that they would have to pay from an acceptable alternative supplier. If we charge more than that, we won’t get the order. Of course, we could charge them less than that, but we’d be picking our own pocket. Since TCO looks only at its version of production cost, it may either set a price that the buyer will not pay, leading to zero sales, or one that is less, leading to our dollars being left on the table.
The second is mistakenly believing that outsourcing services will save money. Since TCO includes both direct and overhead costs, if it's used to compare internal production costs with a price for outsourced services and the TCO cost is more, we may conclude that outsourcing is the correct choice. The obvious problem with this is that the TCO number includes overhead and equipment costs that will continue, whether we outsource or not. The proper comparison is direct costs only versus outsource costs. Obviously, this is only true if the equipment and plant facilities are already in place. If they’re not, it may be attractive to outsource, particularly if the business is considering entering new markets and wants to test the waters before investing. Unfortunately, in that situation, a hypothetical TCO might suggest that such a test should not be made.
The third is the ability to make calculations about profitability that will match year-end results. Because the TCO process must make assumptions about machine utilization and allocations of overhead between machines, the chance of these being exactly correct and thus the sum of all the indicated job profits equaling the enterprise profit is very remote. There is simply no way to calculate individual job “profit” and expect it to equal or even to approximate year-end enterprise profit. What can be done is to calculate individual job contribution to overhead (sales less materials, wages and commission) and compare it to the overhead for the period. If there is an excess of contribution, it should reasonably approximate enterprise profit.
The reality is that TCO completely ignores the issue of “value added” that all production equipment investments should be judged by. It focuses on “Total Costs” to the exclusion of attempting to evaluate how the investment will produce a return, and when that return is likely to be realized. It seems to assume that the effect on a particular firm’s income statement, which will result from the investment decision, is less important that the ultimate cost of this decision. In fact, one of the charts included in the article treats revenues as a “given,” with cost comparisons that vary from 5 to 30 million impressions per month ... as if a 600% variation in expected volume is merely a data point!
The article seems to assume that there is no difference between a cost incurred today, and one incurred five years from now ... in effect, it ignores the important consideration of the timing of the cash flows, because it treats future operating costs as equivalent to the initial cost of a decision. If capital were available in unlimited amounts, at no cost, that might be the case, but whether from stockholders, or lenders, all capital must be paid for over time, until it has been returned to the one that provided it! So the “time value of money” is clearly important.
Then, the analysis mixes investment and operating costs, while separating the operating costs from the benefits of the increasing revenues that they should be expected to produce. This artificial separation does simplify the analysis, because it’s much easier to predict costs than it is to predict revenues. But ultimately the return that all capital investments must produce in order to return the capital they require comes from the net result of revenues and expenses, and the most critical pieces of information that managers must address in all such decisions is, what will the investment change in terms of marginal contribution, and when will these changes be realized?
Finally, and perhaps most importantly, a TCO approach to investment analysis continues the deeply flawed argument that has persisted for so long in the printing industry, namely that prices are based on total producer costs. There may have been a time once when that was at least partly true, when the demand for print output in the market exceeded the existing supply. But since the incredible leaps in technology in printing have dramatically increased the overall supply of print capability in nearly every market - while the dynamics of print purchasing has actually begun to limit the total print demand while more narrowly focusing the products produced - the “fully burdened” production costs have become much less important than the basic contribution which new revenues can be expected to produce.
Ultimately investment decisions need to rely on the answer to the apparently straightforward question of “will the benefits of this decision exceed the (total) costs?” Determining the Total Cost of Operations is certainly a component of this analysis, but only one of a number that require a much more thoughtful approach than what's presented in the article.
Bob Lindgren is the management and business advisor for Printing Industries Association of Southern California and its president/CEO Emeritus. He has worked with printers both in Los Angeles and Chicago for more than 50 years and has an MBA in accounting and finance from the University of Chicago.
Gerry Michael is a CPA/consultant who has focused his practice on the printing industry for nearly 35 years, first as the founder of GA Michael & Company, and later as Graphic Arts lead partner at Carlson Advisors. Currently, he is a consulting principal with the firm of Falco, Sult Inc., and works with printers across the country on management and strategic planning issues, and is a frequent speaker at industry meetings, and contributor to various industry publications.