Lcc of management client relationship
- 1. T h e Possibilities of Life Cycle Costing in Outsourcing Decision Making Anni Lindholm ; Petri Suomala 1 2 1 Researcher, Tampere University of Technology, anni.lindholm@tut.fi 2 Senior researcher, Tampere University of Technology, petri.suomala@tut.fi Abstract The idea of outsourcing is to achieve the optimal performance within a company and a supply chain. Outsourcing decisions, therefore, require life cycle analysis of anticipated changes concerning all relevant costs, including indirect ones, to avoid undesired surprises. Life cycle costing (LCC) is an approach which aims at producing comprehensive cost information for decision makers by estimating the costs incurring in the future and by monitoring the costs during the life cycle. In the context of outsourcing, LCC can provide useful information for both customers and suppliers. The aim of this paper is to discuss the possibilities of life cycle costing in outsourcing decision making and companies’ ability to accomplish comprehensive cost assessments on the basis of empirical evidence about the present practices of life cycle costing. The study indicates that decisions are rarely made within a long-term perspective and cost consciousness in companies is often quite poor. Because the field of life cycle costing is problematic for many reasons, its use has been limited on the practical level. However, LCC has good alignment with outsourcing objectives and it is a potential tool for outsourcing decision making. Keywords life cycle costing, outsourcing, cost management, life cycle Introduction Changes in supply chains have an influence on both suppliers’ and customers’ business. In addition to pure
- 2. products, the suppliers of machines and equipments offer different services to customers throughout products’ life cycles, which aims at securing long term revenues (Markeset & Kumar 2004). Increasing focus on core competencies make customers buy more and more services outside the own company. This trend creates a need for both customers and suppliers to get to know the total cost of the ownership of an asset or a particular operation. This situation can be seen as a challenge for cost accounting in which life cycle costing may also have some role. Approaches such as life cycle costing (LCC) (e.g. Taylor 1981; Woodward 1997) and total cost of ownership (TCO) (e.g. Ellram 1995) aim at providing decision makers with comprehensive cost information on investment alternatives. Whilst it is sometimes difficult to identify the exact difference between these two (see Ellram 1995, 5), a more serious problem seems to be the unsatisfactory level of practical applications of any of these comprehensive cost analysis approaches. The management of fragmenting value chains requires relevant and comprehensive cost information that often extends the boundaries of a single firm. If companies fail to sufficiently track their own costs, which is often the case (Karjalainen et al. 1999; Sievänen et al. 2001), they will face serious problems in evaluating the economical effects of outsourcing and new value chain designs.
- 3. The literature of life cycle costing is mostly conceptual in nature and there is little information about how the concept is applied or about the extent of its use. The application of different costing concepts, including life cycle costing, has been examined in some studies concerning cost accounting practices in general. These studies have indicated that only a few percent of companies use life cycle costing (Hyvönen 2000; Lukka & Granlund 1996). However, the results should be looked at critically because the concept of life cycle costing has not been defined clearly in connection with these studies. The aim of this paper is ? To find out what kind of information life cycle costing can provide in an ideal case ? To find out what kind of information is needed in outsourcing decision making ? To describe the present state of life cycle costing on the basis of two web surveys, supplemented by a series of interviews ? To discuss the possibilities of life cycle costing in outsourcing decision making The paper is based on literature and on empirical evidence about the current practices of life cycle costing. The empirical data were gathered through two web surveys, which were supplemented by interviews. The literature review focused on life cycle costing and outsourcing. Literature review Life cycle costing (LCC) Life cycle costing (LCC) is a method which is used to estimate costs on a whole life cycle basis and to monitor the incurred cost throughout the life cycle (Taylor 1981; Woodward 1997). Life cycle costs of a product often exceed the initial purchase cost and it may also be that the costs of alternative products do not behave similarly in different phases of their life cycle (e.g. Barringer & Weber 1996). However, there is evidence that acquisitions of products are usually made simply on the basis of the initial purchase cost (e.g. Ahmed 1995). Life cycle costing is concerned with optimizing the total costs in the long run, which requires considering the trade-offs between different cost elements during the life phases of a product (e.g. Taylor 1981). The aim is to get a comprehensive estimation of the total costs of alternative products or activities in the long run. It is usually possible to affect the future costs beforehand by either planning the use of an asset or by improving the product or asset itself (Markeset & Kumar 2004), which is a basis for life cycle costing. Life cycle costing is not limited to forecasting of future costs in the beginning of a life cycle. Regarding the control of the whole life costs, it is essential that the costs be monitored throughout the life cycle (Taylor 1981; Woodward 1997). To provide a source of intelligence, it is essential to know the accrued cost of a particular product or service and the behavior of different cost elements in different phases of the life cycle. Companies’ costing practices form the basis for cost monitoring during the life cycle. In this context the allocation of costs to specific products is central. In addition to financial information, collection and analysis of operational data is an essential part of life cycle costing. The aim is to monitor the product’s performance in operation and get empirical information on which to base future decisions. The focus of LCC changes during the product’s life cycle. At the beginning of life cycle, LCC is mainly estimating of future costs. Over time, the focus of LCC shifts to monitoring the incurred costs. Figure 1 illustrates the different aspects of the LCC approach.
- 6. 23 45 67 8 9101112 Figure 1. The changing focus of life cycle costing during a product’s life cycle (Adapted from Suomala et al. 2004). On the basis of the literature it seems that life cycle costing has first referred to forecasting of future costs at the acquisition phase of products (Asiedu & Gu 1998; Emblemsvåg 2001). From the outset, life cycle costing has been talked about in many different contexts and, moreover, there seems to be a confusion about the concepts related to LCC. For example, the total cost of ownership (TCO) approach is usually associated with determining the total cost of ownership of a particular product (e.g. Ellram 1995; Ellram & Siferd 1993). The TCO approach tends to emphasize the costs associated with buying a particular product from a particular supplier (e.g. Ellram 1995). Life cycle costing focuses primarily on costs incurring after the purchasing, and pre-transaction costs tend to be de-emphasized. However, on the practical level these approaches are quite similar, while the main goal is to get comprehensive cost information about particular products or activities. There are many challenges in life cycle costing. First of all, forecasting of future costs is always inexact, so the calculations are based on information which to some extent includes factors of uncertainty (Asiedu & Gu 1998). Because of the inadequacies of companies’ costing practices, monitoring of costs during the life cycle is not accurate enough and there is not enough information for the successful application of life cycle costing. Many barriers to utilizing approaches based on life cycle thinking have been recognized, such as inadequate costing data, non-uniform costing practices and suspicious attitudes towards the approaches (e.g. Ellram 1995; Järvinen et al. 2004; Suomala et al. 2004). It seems that adoption of applications based on life cycle thinking has been very slow on the practical level, except for a couple of industries, such as the military sector and construction industry.
- 7. Collecting of cost information over products’ life cycle is also insufficient in most cases. (Ellram & Siferd 1998; Woodward 1997). Furthermore, the definition of the product – that is the scope of LCC analysis – is a fundamental issue in the realization of life cycle costing. From the costing perspective, a product can be seen as a bundle of activities: the manufacturing or the utilization of a product, for instance, requires a number of activities carried out by organizations. The activities require certain resources, which produce costs (Turney 1991; Kaplan & Cooper 1998). Seeing a product as a bundle of activities enables also a process view, in which the scope of a LCC analysis does not have to be a physical product but any object that can be associated with a number of activities. Outsourcing A trend towards outsourcing has been strong in a wide variety of companies and in different parts of the supply chain in recent years (e.g. Fill & Visser 2000). Generally speaking, outsourcing refers to practices of transferring out activities earlier performed in-house. The trend of outsourcing started from transferring of companies’ non-core activities, such as maintenance, to outside service providers. There has also been an interest towards outsourcing of the ownership of fixed assets or the whole manufacturing process (Markeset & Kumar 2004). In the literature, outsourcing has been discussed mainly from the viewpoint of customers and the effects of outsourcing on suppliers’ business have been ignored. For example, the suppliers of machines and equipment nowadays provide different services to their customers in addition to pure products during a product’s whole life cycle, which generates a need to examine the cost effects of the changes in business from the supplier’s point of view (Laine et al. 2004). According to Winkleman (1993), two basic drivers for outsourcing are cost reductions and a strategic shift in the way of managing the business. There are also many other reasons for outsourcing, such as increased access to new technology or improved quality and efficiency (Fill & Visser 2000). It has been noted that many companies are motivated primarily by the search for short-term and direct cost reductions (Kakabadse & Kakabadse 2000). On the other hand, outsourcing may principally be seen as a strategic decision, which cannot be explained by cost issues alone (McIvor et al. 1997). However, strategic reasons must not be an excuse for neglecting the estimation of cost effects on decision making (Kanniainen et al. 2002). When Karjalainen et al. (1999) examined outsourcing in the field of production outsourcing, they found out that comparative profitability and cost calculations were not done in every case when making the outsourcing decision. The main reason for not making the calculations was that strategic factors seemed to have the main influence on decision making. There are many costs that outsourcing may affect. The costs of outsourcing process are one issue. In addition, after the outsourcing decision has been made company’s direct and indirect costs may behave differently than before. However, many companies make outsourcing decisions primarily on the basis of direct costs (Blaxill & Hout 1991), which do not give a clear picture of the total cost effects of outsourcing from the viewpoint of both the customers and suppliers. First of all, the outsourcing process can be costly, and it may be that this is not taken into consideration when evaluating alternative ways of action (Ellram & Siferd 1998). Also the costs associated with managing the customer-supplier relationship, such as order- supply process or monitoring, may increase due to outsourcing (Vining & Globerman 1999). In addition, adopting the changes of outsourcing may cause indirect or hidden costs, such as an increase in administrative costs (Garaventa & Tellefsen 2001). The costs of changes in capacity utilization should also be taken into account in outsourcing decision making (Kanniainen et al. 2001). It has to be noted that outsourcing may lead to unused capacity, or alternatively, investment requirements may arise if the company is not going to outsource particular activities.
- 8. 23 45 67 8 9101112 Figure 1. The changing focus of life cycle costing during a product’s life cycle (Adapted from Suomala et al. 2004). On the basis of the literature it seems that life cycle costing has first referred to forecasting of future costs at the acquisition phase of products (Asiedu & Gu 1998; Emblemsvåg 2001). From the outset, life cycle costing has been talked about in many different contexts and, moreover, there seems to be a confusion about the concepts related to LCC. For example, the total cost of ownership (TCO) approach is usually associated with determining the total cost of ownership of a particular product (e.g. Ellram 1995; Ellram & Siferd 1993). The TCO approach tends to emphasize the costs associated with buying a particular product from a particular supplier (e.g. Ellram 1995). Life cycle costing focuses primarily on costs incurring after the purchasing, and pre-transaction costs tend to be de-emphasized. However, on the practical level these approaches are quite similar, while the main goal is to get comprehensive cost information about particular products or activities. There are many challenges in life cycle costing. First of all, forecasting of future costs is always inexact, so the calculations are based on information which to some extent includes factors of uncertainty (Asiedu & Gu 1998). Because of the inadequacies of companies’ costing practices, monitoring of costs during the life cycle is not accurate enough and there is not enough information for the successful application of life cycle costing. Many barriers to utilizing approaches based on life cycle thinking have been recognized, such as inadequate costing data, non-uniform costing practices and suspicious attitudes towards the approaches (e.g. Ellram 1995; Järvinen et al. 2004; Suomala et al. 2004). It seems that adoption of applications based on life cycle thinking has been very slow on the practical level, except for a couple of industries, such as the military sector and construction industry.