Constructing a Total Cost of Ownership supplier selection methodology based on Activity-Based Costing and mathematical programming

In this paper we elaborate on a Total Cost of Ownership (TCO) supplier selection methodology that we have constructed using real life case studies of three different industrial components groups in a firm. These case studies are presented in this article. Analysing the value chain of the firm, data on the costs generated by the purchasing policy and on supplier performance are collected using Activity-Based Costing (ABC). Since a spreadsheet cannot encompass all these costs, let alone optimise the supplier selection and inventory management policy, a mathematical programming model is used. For a specific component group the combination of suppliers is selected that minimises the TCO. TCO takes into account all costs that the purchase and the subsequent use of a component entail in the entire value chain of the company. The TCO approach goes beyond minimising purchase price and studies all costs that occur during the entire life cycle of the item in the organisation. Possible savings of between 6% and 14% of the total cost of ownership of the current purchasing policy are obtained for the three cases. ABC is not an optimisation tool as such, but provides important accurate input to the optimising mathematical program, whereas the Operations Research literature usually only distinguishes between variable and fixed costs. We show that the integration of both delivers better results in the setting we have studied.