Chapter 2 of 4

Supplier Selection and Total Cost of Ownership

3 sections · ~6 min read · 3 practice questions · part of Procurement & Sourcing

Learning objectives

  • Build a weighted scoring model that includes both price and non-price criteria
  • Compute a simple Total Cost of Ownership (TCO) and explain the components
  • Recognize when a low unit price is more than offset by hidden costs

Beyond unit price

Unit price is the most visible cost in a sourcing decision but rarely the only one. Other components include inbound freight, duties or tariffs where applicable, receiving and inspection labor, warranty or return cost, downtime or rework caused by quality issues, inventory carrying cost driven by lead time and reliability, and administrative cost of managing the supplier. A supplier with a 2 percent higher unit price and a one-week shorter, more reliable lead time can be cheaper in total cost than the lowest bidder. TCO is the discipline of estimating all of these and putting them in the same units, usually dollars per part per year, before deciding. The estimate does not need to be perfect; it needs to be transparent enough that two competing offers can be compared apples to apples.

Weighted scoring models

A weighted scoring model lists the criteria that matter (price, quality, lead time, financial health, technical capability, sustainability, geographic risk), assigns each a weight summing to 100 percent, scores each supplier on a consistent scale (commonly 1-5), and multiplies. The strength of the model is the conversation it forces about which criteria actually matter and how much. The weakness is that the scores are subjective, so the team should calibrate by scoring one supplier independently and comparing, then adjusting the rubric. Price should usually be a single, explicit criterion (price per unit or total contract cost) and not be smuggled into other scores. A common anti-pattern is to score 'total cost' across multiple non-price criteria, which double-counts and biases the result toward whichever supplier the team already knows.

Make-or-buy and the cost of switching

The make-or-buy decision is a TCO question with a switching cost attached. If the firm makes in-house, it pays direct labor, variable overhead, and capital; if it buys, it pays a supplier price plus the costs above. The TCO comparison should include the cost of capacity the firm has to carry to meet demand variability (a hidden cost that buys often let the supplier absorb) and the strategic value of retaining the capability (a benefit that buying sacrifices). Switching cost matters when changing suppliers involves tooling, requalification, retraining, or inventory build-up. A useful rule is to require payback of switching costs within twelve to eighteen months for the change to be worth it on financial grounds alone; longer payback is acceptable only when there is a strategic reason such as resilience.

Worked example

Problem

Two suppliers offer the same part. Annual demand is 50,000 units, weekly demand standard deviation is 48 units, both suppliers hold their quoted lead time reliably, order cost is $100 per order, and the annual holding rate is 25 percent of unit price. Supplier X: unit price $4.20, inbound freight $0.30 per unit, expected defect rate 1.5 percent with a warranty cost of $15 per defective unit, lead time 4 weeks. Supplier Y: unit price $4.50, inbound freight $0.20 per unit, defect rate 0.5 percent, lead time 2 weeks. Estimate annual TCO for each with safety stock at k = 1.65, then find the defect rate at which Supplier Y would break even.

Step by step

  1. Purchase cost: X = 50,000 x $4.20 = $210,000. Y = 50,000 x $4.50 = $225,000.
  2. Freight: X = 50,000 x $0.30 = $15,000. Y = 50,000 x $0.20 = $10,000.
  3. Warranty: X = 50,000 x 0.015 x $15 = $11,250. Y = 50,000 x 0.005 x $15 = $3,750.
  4. Holding cost per unit per year: X, h = 0.25 x $4.20 = $1.05. Y, h = 0.25 x $4.50 = $1.125.
  5. EOQ = sqrt(2 x 50,000 x 100 / h). X: sqrt(10,000,000 / 1.05) = sqrt(9,523,810) = 3,086 units. Y: sqrt(10,000,000 / 1.125) = sqrt(8,888,889) = 2,981 units.
  6. Orders per year: X = 50,000 / 3,086 = 16.20. Y = 50,000 / 2,981 = 16.77.
  7. Ordering cost: X = 16.20 x $100 = $1,620. Y = 16.77 x $100 = $1,677.
  8. Cycle stock holding cost = (EOQ / 2) x h. X = 1,543 x $1.05 = $1,620. Y = 1,490.5 x $1.125 = $1,677.
  9. Safety stock uses sigma over the lead time = sigma_d x sqrt(L), since both lead times are reliable. X: 48 x sqrt(4) = 96 units, so SS_X = 1.65 x 96 = 158.4 units. Y: 48 x sqrt(2) = 67.9 units, so SS_Y = 1.65 x 67.9 = 112.0 units.
  10. Safety stock holding cost: X = 158.4 x $1.05 = $166. Y = 112.0 x $1.125 = $126.
  11. Total TCO: X = 210,000 + 15,000 + 11,250 + 1,620 + 1,620 + 166 = $239,656. Y = 225,000 + 10,000 + 3,750 + 1,677 + 1,677 + 126 = $242,230.
  12. Gap = $242,230 - $239,656 = $2,574 in favour of Supplier X.
  13. Break-even defect rate for Y: Y would need to cut warranty cost by $2,574, from $3,750 to $1,176. That implies a defect rate of 1,176 / (50,000 x $15) = 0.00157, or about 0.16 percent.

Answer. Annual TCO: Supplier X = $239,656; Supplier Y = $242,230. Supplier X wins by about $2,574 per year. Note where the money actually is: the $15,000 purchase-price premium for Y is the whole story, and the freight, warranty, ordering, and inventory advantages Y enjoys give back only about $12,400 of it. Y breaks even only if its defect rate drops to roughly 0.16 percent. The wider lesson is that shorter lead time is worth surprisingly little here in pure inventory terms (about $40 per year of safety stock), because 50,000 units a year on a 2-to-4-week lead time simply does not tie up much stock. Lead time earns its keep through responsiveness and stockout avoidance, which this TCO model does not price.

Practice

Work each question before opening the solution.

  1. A weighted scorecard gives Supplier A 4.2 and Supplier B 3.9, but the price criterion was scored with subjective 'total value' language rather than a dollar number. What is the risk and how would you fix it?

    Show solution for question 1

    Risk: the team is double-counting price into other criteria and biasing the result toward the supplier they prefer. Fix: replace the price criterion with a calculated total contract cost per year, keep it separate, and disclose the weight to all bidders.

  2. Supplier Z quotes a 5 percent lower unit price but its lead time is twice as long and unreliable. Why might the firm's total cost rise even though unit cost falls?

    Show solution for question 2

    Longer and unreliable lead time raises safety stock (scales with sqrt of L) and the working capital tied up in pipeline. The firm may also face more stockouts and expediting charges, and order batching becomes more expensive because the firm has to commit further in advance.

  3. A make-or-buy analysis shows in-house cost is $4.85 per unit and supplier quote is $5.10 per unit, but the supplier can scale capacity up by 30 percent in 60 days while the firm would need nine months and $2 million to add equivalent capacity. What does this tell you about the strategic value of buying?

    Show solution for question 3

    Buying carries a $0.25 per unit cost penalty but eliminates $2 million of capital and gives the firm agility the in-house option cannot match. The right comparison is TCO plus the option value of flexibility; in a growth or volatile-demand market, the buy option is usually worth more than the per-unit savings of making.