The Cost Iceberg
There’s this concept called the Cost Iceberg, which refers to the idea that like an iceberg, the total cost of an order might not be evident at first glance.
The iceberg is an oft-used visual metaphor, especially in the realm of spending.
Above the surface are visible costs (i.e., sticker price or the number quoted by a vendor). That doesn’t account for the value this purchase stands to add to your business. Nor does it cover how much you’ll pay for repairs or the money you’ll lose when that system fails.
Under the surface are indirect costs (i.e., freight and delivery, installation, training) that represents the total cost of ownership (TCO).
Before you start buying, it’s important to paint a clear picture of all costs.It’s those hidden costs like time invested, customization, logistics, and so on—that may end up eating into profits. Click To Tweet
Here are five areas to consider when evaluating a potential purchase or you’ll risk paying more than necessary.
Installation costs might not be included in an initial estimate. Generally speaking, procurement will issue a request for proposal when sourcing large pieces of equipment or IT solutions.
When buyers review these proposals, the first thing they’ll consider is the price, combined with delivery costs. That’s not the end of the story.
If the solution calls for installation, it’s vital to consider the set-up fees and the process.
Be sure to ask the vendor if the installation is included with delivery or if you’ll need to pay extra to have someone do the job.
Additionally, is this something you can do internally? If so, what are the costs of handing off installation duties to an employee vs outsourcing installation to a third-party technician?
Finally, it’s worth looking at the set-up in terms of complexity. Will you be able to swap out parts yourself? Make changes to the system? If you’ll need to contact a third-party every time something needs to be updated or repaired, it might not be worth the trouble.
Maybe the initial price looks good, but once the product arrives, you’re stuck with a bill twice the amount listed in the initial quote.
How to combat this? Well, we covered this in our last article, where we talked about the incoterms buyers need to know. These terms give both buyer and seller a clear understanding of who is responsible for what costs such as insurance, freight, and customs documents.
We won’t get into the nitty-gritty of shipping and the transfer of responsibility, but buyers need to ask sellers detailed questions about shipping terms, and total cost—product as well as delivery.
Is training included, or is that another hidden cost? If training is required, your contract should describe who will be offering the training, how many sessions are included in the price, and whether ongoing training is needed—and included in the quote.
Whether you’re purchasing a sophisticated software suite, an IT solution, or new equipment, you’ll need to look at the training and onboarding efforts associated with the purchase.
In some cases, you might have to pay extra for a trainer to come to your facility to show your staff how to use the new equipment. Which, of course, means paying them for extra hours or taking time away from daily operations to learn something new.
If the purchase is software or computer equipment, consider ease of use as much as price. A complicated solution is going to require much more training and may lead to costly mistakes down the road.
Is this something that’s going to increase labor costs? Before you sign any contracts, know your exact operation cost. Operation labor is sometimes overlooked during the supplier evaluation phase, but it should be given priority.
There’s this Six Sigma concept known as the Cost of Quality. This idea refers to the costs associated with products or equipment that doesn’t entirely conform to the buyer’s requirements.
So, you’re left spending time on redesigns, testing, and repairs that either mean delays or an investment in overtime or outsourced help. Savvy buyers understand that they must weigh operation labor against the initial quote. The cheapest solution, of course, won’t look so attractive when you’re adding materials and labor.
Operation labor also extends to other areas. For instance, how long it takes to process an order, accounting and legal fees, utilities, and repairs.
Operating costs also must be reviewed on an ongoing basis—both to understand the true cost of purchase and make sure employees are using their time wisely.
These reviews give internal stakeholders the ability to make accurate forecasts over time. Are costs expected to increase or decrease? And how will the organization plan for those fluctuations?
What happens if the equipment breaks? Does it require a service contract? Or are you on your own?
Maintenance—especially for large pieces of construction equipment—can be costly both in terms of parts and labor, as well as unplanned downtime.
Consider the whole picture when evaluating the cost of a particular product:
- Are parts costly?
- What about downtime?
- How much is preventive maintenance?
When it comes to hidden costs, downtime is a big one. But it’s also something that’s hard to predict. But shutting down production can mean losing thousands of dollars at a time.
A preventive maintenance program can help you increase the lifespan of a piece of equipment and reduce the likelihood of surprise breakdowns.
Spend some time discussing preventive maintenance with the vendor–how long is a typical check-up visit? How long does it take to fix common problems? Are parts and labor included?
Additionally, read as many reviews as possible—find out if other customers experienced a lot of maintenance issues or if the parts seem costly compared to the equipment as a whole.
In some cases, parts may be hard to find. Weigh costs against the time spent waiting around for a particular order.
Replacement costs are the costs involved with replacing a company asset of the same value. Assets include significant purchases such as buildings or large pieces of equipment. Some assets depreciate on a straight line basis, meaning the cost of an asset is divided by the amount of time that it will be useful. In other cases, depreciation is accelerated, like when you drive a new car off the lot and it drops in value.
Be sure to consider replacement cost; many companies don’t generate enough revenue to cover equipment replacements. As such, companies need to plan for asset purchases, setting money aside for the inevitable.
The cost of disposal is another area where costs add up unexpectedly. Disposal costs, or exit obligations, represent the future liability of getting rid of an item down the line. These costs include the losses or gains associated with selling a piece of equipment, or those fees associated with recycling and hauling away an item that no longer works.
A company might buy a piece of equipment, then use it for a few years until the machine is obsolete. The machine’s book value can be calculated by subtracting the depreciated cost from the original price. Ideally, you’ll be able to resell the item for at least book value— which accounting would log as a gain. If you have to discount the machine, the below-book sale would be considered a loss.
Receiving and Stocking Orders
We talked about delivery and freight costs, but hidden costs extend to freight processing as well. When you receive an order, you’ll need to pay for your staff or the delivery driver to unload the goods.
Once the items are off the truck, you’ll need to make sure the shipment matches the initial order and note any discrepancies. Review the product quality, colors, sizes, to ensure everything matches to PO.
From there, you’ll need to account for the paperwork involved with processing invoices and matching them to POs. If the supplier is disorganized or makes a lot of errors, this may end up wasting a great deal of time. For that reason, it’s crucial that you consistently review supplier performance to make sure they hold up their end of the bargain.
The Cost Iceberg Requires Ongoing Evaluation
Any purchase is subject to hidden costs. Some are administrative tasks or internal labor, while others like surcharges, freight, and installation can increase invoices considerably.
As you consider supplier quotes, discuss these questions before negotiating a contract. One supplier might give you the lowest price, but subject you to a whole lot of hidden costs.
This diagram shows that managing the cost iceberg is an ongoing effort. With each acquisition, you’ll gain more insight into how you can improve specification and work with the vendor to reduce spend.
One key element in the supply chain is ensuring that all information is available to all internal stakeholders—contracts, terms, a preferred list of buyers, and purchasing history.
ProcurementExpress.com brings more transparency to the purchasing process and can store supplier info, track your order status, and review budgets and spending in real time.
Contact us today, and we’ll set up a demo.