Unless you are an accountant, the two terms “TCO” and “ROI” can be confusing at times, which is unfortunate as they are important concepts in running your business. Let’s see if we can explain them without you having to be a finance major. We’ll start with definitions.
The total cost of an item may be more than you think
TCO, or the Total Cost of Ownership, includes all costs of acquiring and operating a purchase, most often over the economic life of the unit. It may include a number of different costs depending on what the purchase is. As an example, the TCO for a piece of manufacturing equipment may include the purchase cost of the unit, non-refundable taxes, shipping costs, import duties, installation costs, annual maintenance plans, and major repairs over a specified number of years. Note that different organizations may have varying definitions of which costs should to be included in this calculation. The important point is the calculation formula should be consistent when you are comparing alternatives.
Plan ahead by calculating the total value of a purchase
ROI, or the Return on Investment, is the net economic benefit from a planned or actual purchase. The formula is the net financial benefit of purchasing the unit (increase in cash flow minus the purchase cost) divided by the purchase cost. For example, an investment sold for $50,000 in revenue and with a cost of $40,000 would have an ROI of 25% (($50,000-$40,000) divided by $40,000). A more complex example would include the residual value of the unit. ROI can be of limited value in some circumstances because the default calculation does not include the passage of time, i.e. one year versus two years.
Know your TCO and ROI before you spend money
So how do you use these numbers when evaluating investments in your equipment rental business? ROI should be used to determine whether you should make the investment in the first place. If you calculate a negative ROI, you definitely shouldn’t make the investment. If you have a minimum ROI you want from your investments, any investments not attaining that standard are also not viable. Investments with an ROI in excess of your minimum standards should be ranked in terms of highest return and, in the absence of any other factors, should be added to your portfolio until you have expended your investment capital. Be sure to consider time factors.
Unexpected events can be like playing Whack-a-mole
Once you have decided whether to make the investment, TCO can be used to assist you to pick from the alternatives for any given investment. For example, if the decision to purchase a new software system or a new piece of equipment is made based on an ROI calculation, then TCO could be used to evaluate the various available options. If these turn out to be substantially more expensive than expected, then the ROI previously calculated is no longer valid and should be recalculated using the new information. Remember TCO includes all costs. Vendors often try to hide various costs that may come up during the life of the unit. It is your job to find them out and make sure they won’t be unexpectedly raising their ugly heads when you least expect them. Have you ever played Whack-a-mole? Just when it seems you have everything under control, another one of those moles pops up its head. Hopefully, your negotiations don’t turn out like that.
A point to consider is sometimes the ROI calculation can include benefits that can’t be quantified. For example, how much is a new equipment rental accounting system worth to you? Any attempt to calculate benefit numbers in this situation are likely to result in “soft” ROI numbers, in other words, numbers that can’t actually be supported by any concrete evidence or estimates. These benefits could include improvements in efficiency and cost savings, which are very difficult to quantify unless you can justify laying off staff afterwards. Software vendors can be quick to suggest that a new system “can reduce inventory by 10%” or “increase sales by 5%”. Easy to suggest, much harder to prove. Calculate the benefits yourself.
When doing nothing causes you to move backwards
An unexpected benefit of a properly calculated ROI is it can reveal the costs of doing nothing. Without making the investment, an organization could be losing benefits every day. This is a worthwhile consideration for internal sponsors who are trying to gain approval for new investments.
A study carried out by Nash in 2008 is a bit old but still informative. It stated that 59% of managers reported ROI calculations influenced their investment decisions. Only 41% relied on TCO. There was some sentiment that ROI was a more balanced answer while TCO looked only at the cost side of the equation. That is totally fair but it is important to remember the order of using the two calculations, ROI first, TCO second.
If you are considering purchasing a new equipment rental software system, TCO is a great way to compare the cloud and in-house options available from vendors. A one year TCO calculation is very limited but by comparing the TCO over a three to five year time span, the organization is able to more easily compare apples to oranges, in this case, because these are two very different choices. In-house systems are typically more expensive up-front but gain over the years as cloud systems become more expensive because of the relatively high monthly user license cost. Or at least until you have to buy new servers for the in-house options, or your IT guy quits and you end up with a dud when you hire someone new. An important wild card is the cost of upgrades and customizations. Consider all the costs!
So, to summarize. ROI helps you decide whether you to do something, TCO helps you evaluate the options for that something.
If you need some help determining the ROI and TCO of a new equipment rental software system for your equipment rental business, please contact me directly at 1.877.777.7764 ext. 105.