Page 107 - DCOM206_COST_ACCOUNTING_II

Cost Accounting – II

Notes regardless of the course of action the county takes; only the differential cost of the two
alternatives should influence the decision. If the differential cost of outsourcing the
warehouse function is $340,000 less per year than retaining this function in-house, including
the sunk cost of the consulting services would lead the county to spend $340,000 per year
more than it has to.
Opportunity costs. Another important cost concept in make versus buy decisions is
opportunity cost. Opportunity cost is the lost opportunity of using an asset or resource in
a way other than the chosen alternative. For example, if a suburban government sells a
public swimming pool to a private company to own and operate, the opportunity cost
would include the admittance fee revenue that would have been collected if the pool
remained a public asset. Likewise, the opportunity cost of not selling the pool would be
the revenue from the sale of the pool.
Cover A Multi-Year Period and Discount Future Cash Flows
A cost comparison should cover a multi-year period. This is important for two reasons.
First, a multi-year analysis is more likely to reveal whether outsourcing will generate
long-term savings. A government should experience much of the cost savings related to
outsourcing in later years, as leases and contracts expire and fixed costs become variable
costs. Second, a multiyear contract is usually more attractive to potential vendors, which
creates more competition and drives down the costs of the contract.
In a multi-year analysis, future cash flows should be discounted to their present value.
This ensures that appropriate weight is given to future costs and benefits. Discounting is
the process of converting a future value into its present value.
How to Perform A Make-Versus-Buy Cost Analysis

A make-versus-buy cost analysis involves four basic steps:
Step 1: Define the service
Step 2: Calculate the in-house costs that could be avoided by outsourcing the service
Step 3: Calculate the total costs of outsourcing n Step 4: Compare the cost savings from
outsourcing to the costs incurred
Exhibit 1 illustrates the steps in a make-versus-buy cost analysis.
To simplify the diagram, the analysis is limited to a single year. In actual practice, the
analysis should cover a three- to five year period, and steps 2b through 4 should be
repeated for each year. The totals for each year should be discounted to their present
value.
Step 1: Define the service. The first step in a make-versus buy cost analysis is to clearly
define the government service that is being considered for outsourcing. In other words,
specify the quality and quantity of the service and the output and outcomes that are
expected. This is necessary so that there is an apples-to-apples comparison between the
service the government is already providing and the service proposed by outside
contractors. If a service is vaguely or incorrectly defined, the in-house costs may be higher
(or lower) than the contract costs simply because the government is providing more (or
less) service than what is documented in the request for proposals.
When specifying the quality and quantity of the service, it is important to investigate
whether government employees informally provide additional services to residents. For
example, a parks and recreation department may perform tree trimming for elderly
residents upon request, or may deliver wood chips free of charge.
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