Procurement Practice #1: TCO, Value-based, and NPV

Modern procurement techniques are made simple.

My previous posts mainly elaborated on the theoretical and conceptual aspects of procurement. 

However, as I work on my ever-growing portfolio of training courses, I look for simple yet valuable practical exercises to blend those with the theory.

The following case came from a real-life inquiry demonstrating a few modern procurement techniques. I decided to share it with my readers.

A showcase for sustainable procurement

My client in consulting asked me to help promote sustainable procurement and justify some additional investments into green products. 

I wanted to pick a typical hands-on example. So, I asked for details about their office air-conditioners. 

This company mainly used HVAC systems in its office buildings, which landlords installed. Occasionally, it used air conditioning in smaller offices and hardware rooms.
 
Their aircon was standardized; lately, they only used a particular 2017 model by Mitsubishi Heavy Industries.  
  
Having looked at critical technical characteristics – cooling area and power – I found the newer 2022 model with identical parameters (exactly 7.1 kW of power and 70 sq meters of  service area.) 

Indeed, the only problem with the new model was its price, which was 30% higher than the old one.

First, we calculated the 5-year TCO as follows.

TCO of air conditioners


Two tangible benefits of operating a new air conditioner model are refrigerant and power consumption savings. When we calculated both, the old vs. new model cost difference shrank to just 3%.

Value-based procurement approach

Second, we attempted to look beyond cost into value aspects. 


Naturally, air conditioners became a matter of concern regarding environmental safety.

The older model uses R410A refrigerant, which will soon be phased out due to the whopping global warming index 2088.

The new model switched onto R32 refrigerant with an index of 675.

Indeed, the 68% improvement in environmental safety may comfortably justify the 3% difference in TCO.

We also checked noise levels to possibly compare the office staff experience. A louder model might've negatively influenced employee satisfaction, but that indicator was almost similar for both models.

NPV-based discount calculation

Finally, we applied the NPV to develop a justified negotiation position.

NPV calculation example

Our investment in the improved characteristics of a newer air conditioner model is $600, which is the absolute difference between the cost of these two models.

In return, we obtained savings on refrigerant refill and energy consumption.

We computed the total value of savings over five years at $505. We should ask for a $95 discount, which would be the balance of our initial investment of $600.

Since we calculate the TCO over an extended period, it will be logical to apply the NPV method.

Assuming a discount rate of 10%, we arrived at the NPV value of—$222, which we lost over that period from our initial investment of $600. We can use this value for our negotiation strategy.

This exercise may seem primitive to seasoned procurement professionals. Yet, its positive side is that it allows us to showcase the richness of our toolset, even for such simple subjects.

P.S. If you liked this exercise, I have many more in my Udemy course “Procurement in Practice.”

P.P.S. If you appreciate hundreds of hours invested in researching and writing this blog, you can buy me a coffee or subscribe for the membership by following this link. Thank you!

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More information on this and other exciting topics can be found in "The Technology Procurement Handbook." It represents 23 years of experience, billions of dollars worth of successful sourcing projects, and 1000s of hours spent on research, analysis, and content creation for the most demanding professional readers.

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