This Module will help you to:

Decide how
many
Decide what
suppliers to
procurement
invite
method to use
& when

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Know how to

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evaluate
offers Use different
methods
effectively

ITC M6:Preface:2
 Possibilities for evaluating
suppliers’ offers

Lowest price
Lowest total cost
of ownership

Weighted scoring ?

ITC M6:U4:4.1-1
 1. Lowest price
 Suppliers’ offers are tested for compliance
against minimum requirements, e.g.:
Does the offer meet your specifications?
Can the supplier deliver on schedule?
 If they meet or exceed these criteria, they are evaluated on the
basis of their offered price, e.g.:
Evaluating offers for supply of office PCs
Meets minimum:
Registered
Supplier Delivery Price Selected:
supplier? Specification
schedule
A Yes Yes No
B Yes Yes Yes $ 42,300 No
C Yes Yes Yes $ 47,500 No
D No
E Yes No
F Yes Yes Yes $ 38,900 Yes
G Yes No
ITC M6:U4:4.2-1
 2. Lowest total cost of ownership
(TCO)

Suppliers are, again, tested for compliance

against certain minimum requirements

If they meet or exceed these criteria, they

are evaluated on the basis of the total cost
of ownership resulting from their offer

ITC M6:U4:4.3-1
 Features of the TCO approach...

It attempts to quantify all costs - and

revenues - associated with a particular
purchase

Some costs may be “negative”,

i.e. there is a cash inflow, such
as when a piece of equipment
can be sold on the second-hand
market or for scrap at the end
of its life
ITC M6:U4:4.3-2
 TCO components:
Purchase cost
Operating costs
Preventive maintenance costs
Repair costs
Cost of disposal
Capital costs
Other costs, e.g. insurance
Other considerations, e.g.: output levels
ITC M6:U4:4.3-3
 Quantifying each cost
3
Example: main TCO 11% %
Purchase price
21%
elements for a high
Electricity
voltage electric motor
65% Maintenance contract
Disposal

Breakdown of total cost of ownership a HV electric motor

Element of cost Year 1 Year 2 Year 3 Year 4 Year 5
Purchase price $50,000
Electricity $30,000 $30,000 $30,000 $30,000 $30,000
Maintenance $5,000 $5,000 $5,000 $5,000 $5,000
Disposal $7,000

ITC M6:U4:4.3-5
 Quantifying each cost
You need to quantify each of the
component costs and tabulate them over
the lifetime of the equipment
In most cases, it is sufficient to look at
total annual costs
You may exclude certain costs if:
 The cost is very small compared with other costs
 The cost can be expected to be similar
for all offers

ITC M6:U4:4.3-6
 Quantifying each cost: issues to
consider
 Your required level of effort and accuracy
 Possible related costs
 Currency
 Structure of the total cost of ownership model
 Treatment of costs already incurred
 Treatment of cash inflows (revenue)
 The cost of employees’ time
 Treatment of inflation
 Assumptions and sources of data
ITC M6:U4:4.3-7
 The importance of the timing of costs
 Different suppliers’ offers are likely to
result in different levels and patterns
 Thus, although the sum of all costs
of two offers is similar, one offer
might involve higher costs in early years
while the other might involve higher
costs in later years, e.g.:
Purchase of production machinery: Summary of costs over time
Offers Year 1 Year 2 Year 3 Year 4 Total cost
Purchase
Supplier X price: $5,000 $20,000 $5,000 $90,000
$60,000
Purchase
Supplier Y price: $3,000 $3,000 $4,000 $90,000
$80,000
ITC M6:U4:4.3-8
 At an interest rate of 10% per year...

Cost of using Supplier X taking interest payments into account

Year 1 Year 2 Year 3 Year 4 Total

Year 1 cost $60,000 $60,000

Interest payments
$6,000 $6,600 $7,260 $7,986 $27,846
associated with Year 1
Year 2 cost $5,000 $5,000
Interest payments
$500 $550 $605 $1,655
associated with Year 2
Year 3 cost $20,000 $20,000
Interest payments
$2,000 $2,200 $4,200
associated with Year 3
Year 4 cost $5,000 $5,000
Interest payments
$500 $500
associated with Year 4

Total $124,201

ITC M6:U4:4.3-9
 At an interest rate of 10% per year...

Cost of using Supplier Y taking interest payments into account

Year 1 Year 2 Year 3 Year 4 Total

Year 1 cost $80,000 $80,000

Interest payments
$8,000 $8,800 $9,680 $10,648 $37,128
associated with Year 1
Year 2 cost $3,000 $3,000

Interest payments
$300 $330 $363 $993
associated with Year 2
Year 3 cost $3,000 $3,000

Interest payments
$300 $330 $630
associated with Year 3
Year 4 cost $4,000 $4,000

Interest payments
$400 $400
associated with Year 4

Total $129,151

ITC M6:U4:4.3-10
 Calculating the TCO using the Net
Present Value (NPV) approach
NPV takes the time-value of
money into account in calculating
the total cost of ownership =
12
9 3
6

It re-states all costs in terms of

the equivalent cost today, i.e. the
“present-day equivalent cost”
E.g. at a 15% interest rate, a cost of $23,000 in
one year’s time = a present-day cost of $20,000

Future costs are thus “discounted” back to the present!

ITC M6:U4:4.3-12
 NPV - the discount rate
The discount rate to use will depend on the cost
(e.g. interest rate) of the source of funding for
the purchase. The funding can include…

 Bank account in credit

 Bank overdraft
 Bank loan X
5
 Issue of shares 2
 Issue of bonds

When various sources are used, the discount rate

is the weighted average cost
ITC M6:U4:4.3-13
 Knowing the discount rate, you can calculate the present-
day cost with this formula:
Present-day = (future cost) x ( applicable discount
cost factor)
You obtain the discount factor from the following table:
Table of discount factors
Discount Year Year Year Year Year Year Year Year Year Year
rate 1 2 3 4 5 6 7 8 9 10
3% 0.9709 0.9426 0.9151 0.8885 0.8626 0.8375 0.8131 0.7894 0.7664 0.7441
4% 0.9615 0.9246 0.8890 0.8548 0.8219 0.7903 0.7599 0.7307 0.7026 0.6756
5% 0.9524 0.9070 0.8638 Or...
0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139
6% 0.9434 0.8900 0.8396
Discount factor =
0.7921 0.7473 0.7050 0.6651
10.6274 0.5919 0.5584

( 1 + r )n
7% 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663 0.6227 0.5820 0.5439 0.5083
8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632
9%
10%
0.9174
0.9091
0.8417
0.8264
0.7722
0.7513
0.7084
0.6830
0.6499
0.6209
0.5963
0.5645
0.5470
0.5132
100
0.5019
0.4665
0.4604
0.4241
0.4224
0.3855

Where: n = No. of years

11% 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 0.4817 0.4339 0.3909 0.3522
12% 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220
13% 0.8850 0.7831 0.6931 0.6133 r = the discount rate
0.5428 0.4803 0.4251 0.3762 0.3329 0.2946
14% 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996 0.3506 0.3075 0.2697
15% 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 0.2472
ITC M6:U4:4.3-14
 An example...
Summary of costs
Today’s
End of End of End of
Supplier purchase End of Year 4
Year 1 Year 2 Year 3
cost
Supplier A’s $35,000 $5,000 $7,000 $7,000 Net cash inflow of
offer $5,000
Supplier B’s $43,000 $3,000 $3,000 $3,000 Net cash inflow of
offer $1,000

At a discount rate of 8%:

Discount factors
Discount Year Year Year Year
rate 1 2 3 4

8% 0.9259 0.8573 0.7938 0.7350

ITC M6:U4:4.3-16
 The result for...
Supplier A
Period Cost 8% Discount Equivalent present-day value
rate
Today – 35,000 N/A 35,000
purchase cost
Year 1 5,000 0.9259 5,000 x 0.9259 = 4,630
Year 2 7,000 0.8573 7,000 x 0.8573 = 6,001
Year 3 7,000 0.7938 7,000 x 0.7938 = 5,557
Year 4 -5,000 0.7350 -5,000 x 0.7350 = - 3,675
35,000 + 4,630 + 6,001 + 5,557 –
3675
Net present
value = $47,513

ITC M6:U4:4.3-17
 The result for...
Supplier B
Period Cost 8% Discount Equivalent present-day value
rate
Today – 43,000 N/A 43,000
purchase cost
Year 1 3,000 0.9259 2,778
Year 2 3,000 0.8573 2,572
Year 3 3,000 0.7938 2,381
Year 4 -1,000 0.7350 -735
Net present $49,996
value

Conclusion:
Supplier A’s NPV is lower by $2,483 (5% lower)

ITC M6:U4:4.3-18
 When to use TCO
Appropriate to use when:
 There are relatively significant ongoing costs after the
purchase has been made.

 There are trade-offs between the purchase price and other

costs such as operating cost.

 The value for money is important. The true value can only
be determined with an understanding of all costs involved.

TCO is usually associated with major capital purchases, but is

generally relevant for a significant proportion of all purchases

ITC M6:U4:4.3-21