Henrique Pereira

Total Cost of Ownership (TCO) is a concept that aims to analyse the actual full cost of purchasing a product, beyond the mere purchase price. It includes factoring all the costs associated with a product or piece of equipment right from the initial purchase price through its maintenance, use and disposal, including operational costs, such as energy consumption, among others, thus combining direct and hidden costs.

Therefore, it is a much more accurate basis for determining the true value of an investment. Reducing TCO is a widely used strategy adopted by companies, as it directly impacts the company’s financials. Subsequently, a reduced TCO can:

• Lead to enhanced long-term financial performance
• Act as a guidance tool for optimising direct and/or indirect costs
• Help determine ROTI (Return on Time Investment) or ROI (Return on Investment)

Over the years, as more and more companies in different industries have adopted the practice of evaluating TCO, many methodologies have been formulated. While there is no global solution for determining TCO, it is recommended to consider the specifics of each activity sector for a more accurate analysis.

Most TCO methodologies, in general, normally include the following significant factors:

• Purchase price: Cost price, including the supplier margin
• Acquisition cost: Purchasing department operations
• Associated cost: Custom duties, packaging, logistics, etc.
• Cost of ownership: Depreciation costs, inventory management, warranty, etc.
• Operation cost: The cost of usage, including utility costs (electricity, water, gas, etc.) and consumables
• Maintenance costs: Preventive and reactive maintenance, spare parts, etc.
• Disposal cost: Costs of recycling or resale, etc.
• Non-quality cost: Non-compliance in processes, etc.

Some of the common challenges we see with the calculation of TCO include companies adopting numerous methodologies and tools; failing to define a singular methodology, which proves to be a challenge for fair comparisons; difficulty in determining the exact scope of operating costs for equipment; and the lack of foresight relating to unpredictable increase in costs over time. This, in turn, significantly impacts the accuracy of the TCO, misleading professionals into poorly informed procurement or maintenance decisions of their equipment.

TCO and the Energy Services industry

When considering new equipment for energy efficiency and retrofit programmes, clients generally feel the initial cost is too high, and thus, finance – or the lack of capital – becomes one of the biggest barriers in commercial energy efficiency programmes. The initial price often causes confusion or does not depict a true picture, as it only reflects one small part of the big picture. Few consider the operational costs – namely, energy cost – repair and maintenance costs, which are usually many times higher than the initial cost.

It is important to gradually change this landscape, through the provision of Energy Performance Contracting (EPC), a form of financing for capital improvements that provides funding for retrofits by leveraging the associated cost reductions.

By implementing a Shared Savings EPC (SSEPC), it is possible to provide all engineering, equipment, capital expenses (CAPEX) and operational expenses (OPEX) for an energy efficiency project. All project costs are subsequently paid for from the savings generated by the project and shared with the owner from day one.

Once the project fees are paid in full, the facility owner will continue to benefit financially from the energy savings. Through this model, the ESCO retains ownership for any new equipment that was installed and financed, which is then transferred to the customer upon contract conclusion or early exit.

The most attractive part of an SSEPC is that there is an ESCO that will finance the project and make sure the customer has the new equipment needed, assuring that the savings will occur, without any initial capital expenditure to the organisation. Facility owners and operators find much value in this type of ESCO service, because it improves operational efficiencies, improves indoor air quality and comfort conditions, reduces maintenance costs over time and provides new equipment by monetising operational savings streams.

By leveraging operational cost reductions, one benefit to the facility owners is that these desirable technologies, which would typically be capital expenditures, can be paid for through savings. The larger benefit is reducing operating costs without capital budget expenditure. This type of EPC approach is based on the transfer of technical risks from the customers to the service providers, based on performance guarantees from the service providers. This agreement allows facility owners to optimise their existing facility’s energy capabilities, enhancing profitability while dramatically reducing their organisational carbon footprint.

Delving further into equipment, it is a fact that in most cases, upgraded or new equipment is needed to implement energy efficiency measures (EEMs). In this scenario, an ideal approach would be for the service provider to finance, design, install and manage energy efficiency measures (EEMs), the equipment for which is leased to customers through the contract period, with the customer not incurring any costs for new equipment repairs or replacements.

The service provider would fund the new equipment, tools, construction equipment, transportation, labour, and other direct and hidden costs. Through the contract term, the service provider would then manage the performance of the EEMs. In this result-oriented approach, energy efficiency savings bring down the equipment costs, thus offering the customer a blended product/service price.

Equally important, by considering all aspects of the equipment TCO in the scope of the EEM, from design to engineering, and from procurement to operation and maintenance, the true return of that investment can also be correctly captured by the savings generated by the EEM, leading to a much more accurate financial calculation of ROI.

For the purpose of this article, let us consider the replacement of high-value equipment – chillers, which in most existing facilities are generally poorly maintained. In this example, the chillers consume AED 200,000 per year in operation cost and AED 50,000 in maintenance cost.

They are also not performing as per expectations in the summer, leading to unaccounted for non-quality costs. A new replacement chiller system costs approximately AED 600,000, and since new chillers are more efficient they bring consumption down to AED 125,000 per year; they also bring annual maintenance costs down to AED 25,000.

A typical ROI calculation would only account for the benefit in operation costs (AED 75,000 per year) to offset against the investment cost (AED 600,000), leading to a simple payback of eight years. In the current market context, this project would never see the light of day.

However, if we factor in the additional yearly maintenance savings (AED 25,000), the simple payback is reduced to six years. Moreover, if an ESCO would now be engaged into an SSEPC project, the customer’s initial investment would be reduced to zero, as would be the maintenance costs (since they are taken care of by the ESCO).

The customer would have a yearly benefit of AED 125,000, considering both operational savings and maintenance savings, and would share this benefit with the ESCO. Assuming the ESCO would take 80% of the savings, the customer would pay AED 100,000 to the ESCO every year, while keeping AED 25,000 in their own pockets. The ESCO would finance the full TCO for this project, leading to an eight-year contract with the customer.

This means that the full TCO of the EEM has been accounted for in the project, with the customer benefitting from AED 25,000 per year of net savings. The customer would receive brand new chillers, meaning postponing future capital expenditures by at least another 15-20 years, without any CAPEX or OPEX costs for the chillers for the next eight years of the contract. This value-proposition represents a major incentive for the customer to retrofit their facilities with the support of an ESCO.

Without TCO analysis, most companies grossly miscalculate their operation and maintenance budgets, which results in uncontrolled downtime, slower decision-making and other site complications. A sophisticated service provider can strive to break the finance barrier that challenges energy optimisation projects. Through financing, it is indeed possible to help other ESCOs, equipment suppliers, services providers and building owners reduce their TCO.

The writer may be contacted at henrique@takasolutions.com.