Calculating the TCO - Total Cost of Ownership - in IT Projects
When embarking on an IT project, it's easy to focus solely on the initial costs.
However, experienced Project Managers understand that the real financial picture is far more complex, where the concept of Total Cost of Ownership (TCO) comes into play.
TCO isn't just about the upfront expenses; it provides a comprehensive view of both short-term and long-term costs.
In this post, we'll dive deep into what TCO is, why it matters, and how to calculate it effectively.
What is TCO?
TCO stands for Total Cost of Ownership; it is a financial estimate that helps you understand the direct and indirect costs of a product or system over its lifecycle.
In the context of IT projects, TCO encompasses not just the acquisition of hardware and software but also the costs for maintenance, operation, and even decommissioning.
What is the lifecycle?
lifecycle is the entire set of sequential stages that a project goes through from initiation to completion.
The project lifecycle often varies by industry, organization, and the nature of the project, but it generally includes the following stages:
Initiation
Planning
Execution
Monitoring and Controlling
Closing
Post-Project
Knowing the TCO of an IT project and applying it in every single stage can significantly impact your decision-making process, helping you:
Budget more effectively
Assess the long-term viability of a project
Compare different investment options
Understand how the investment will affect ROI (Return on Investment)
Components of TCO in IT Projects
Initial Costs
Those can be, Hardware and Software Acquisition, for example buying new servers, systems, licenses, computers, laptops, printers, and
Licenses and Subscriptions, Costs for software licenses, cloud services, or other subscriptions.
Those are the initial backbones to run the operational costs in order to execute your work
Operational Costs
Maintenance and Support: Ongoing costs for keeping the system up and running.
Energy Consumption: Costs of electricity for running hardware.
Employee Training: Costs of training staff to use the new system.
Employee Salary: Costs to maintain the staff to use the new system.
Indirect Costs
Downtime Costs: It is the eventual financial impact of system downtime, if applicable.
Downtime costs can be calculated using various methods, but a simple formula might look like this:
Downtime Cost per Hour = (Lost Revenue per Hour) + (Cost of Idle Workforce per Hour) +
(Recovery Costs per Hour)
Opportunity Costs: these are really easy, those are the costs of not choosing an alternative option.
It is the value of the next best alternative that must be forgone when a decision is made.
In other words, it's what you could have gained from choosing the second-best option when making a choice between two or more alternatives.
Opportunity costs are not always easy to quantify but are important for making informed decisions, both in everyday life and in various professional contexts, including project management and economics.
Businesses usually use financial metrics like ROI (Return on Investment), NPV (Net Present Value), or IRR (Internal Rate of Return) to assess the opportunity costs of different investment options.
Risk-related Costs:
Risk-related costs are the potential costs related to security risks or data breaches.
These risks can range from scope changes and project delays to technical issues and external factors like regulatory changes.
Risk-related costs are a crucial consideration in both the planning and execution phases of a project, as they can have a significant impact on the project's budget and timeline.
Risk costs are divided into three parts: direct, indirect, opportunity
Direct Risk Costs
those are:
Mitigation Costs: Expenses for implementing measures to reduce or eliminate risks.
Contingency Costs: Funds set aside to handle issues that may arise, often calculated as a percentage of the project budget.
Insurance Costs: Premiums for insurance policies that cover specific project risks, such as property damage or liability.
Indirect Risk Costs
those are :
Delay Costs: Costs incurred due to project delays, such as idle labor and extended facility usage.
Reputation Costs: Potential loss of customer trust or brand damage due to project failure or issues.
Legal Costs: Expenses related to legal actions that could arise from project risks, such as contract disputes or compliance failures.
Opportunity Costs
those are:
Resource Reallocation: Costs associated with diverting resources to address risks, preventing their use in other value-generating activities.
Market Risks: Costs associated with market changes that occur during the project, such as price fluctuations or demand changes, which could affect project profitability.
How to Calculating the TCO
The first step in TCO calculation is to identify all the costs that will be associated with the project. This operation is important also to check the financial state of the company and the cooperation between the departments.
The second step is choosing the right time frame for your TCO analysis. Whether it's one year, three years, five years, or months, the time frame should align with the expected lifecycle of the IT asset.
Quantification and Estimation
Assign monetary values to each identified cost. These are the exact numbers or educated estimates based on industry benchmarks or past projects.
Calculation
For example, let's say we have:
- Initial costs of $50,000,
- yearly operational costs of $20,000, and
- indirect costs of $5,000 over a five-year period.
The TCO would be:
TCO= Initial Costs+(Operational Costs×Time Frame)+(Indirect Costs×Time Frame)
Let’s break an example here:
1. Initial Costs: $50,000
2. Yearly Operational Costs: $20,000 (for 5 years, it would be:
( $20,000 * times 5 = $100,000 )
3. Yearly Indirect Costs: $5,000
(for 5 years, it would be $5,000 * times 5 = $25,000)
TCO = $50,000 + ($20,000 * 5) + ($5,000 * 5)
TCO= $50,000 + $100,000 + $25,000
TCO= $175,000
the Total Cost of Ownership (TCO) for this example would be $175,000 over a five-year period.
TCO Models and Tools
Several TCO models and software can assist in this calculation, such as the Gartner TCO model. These tools can help automate the process and make it more accurate.
Best Practices
As I said before, always consider the full lifecycle of the project, and take multiple departments between them to get a comprehensive list of costs (ERP software comes to help) but basically oiling the communication between them is one of the first voices of costs in my experience.
After this, regularly update your TCO analysis as variables change.
Avoid: not considering hidden or indirect costs, ignoring the costs of potential risks or downtime and using too short a time frame for your analysis, especially if you can not compare the same time windows with benchmarks