Page 109 - DCOM206_COST_ACCOUNTING_II

Cost Accounting – II

Notes Contract Administration Costs: The government’s contract administration costs include
all of the tasks necessary to select and manage a vendor over the life of the contract. These
tasks may include reviewing and evaluating RFPs, writing and negotiating the contract,
processing change orders and amendments to the contract, monitoring and evaluating
vendor performance, dealing with disputes, and processing payments to the vendor.
Depending on the type of contract and their own internal processes, state and local
governments can estimate contract costs anywhere from 0 percent to 25 percent. Some
governments base their estimates of contract administration costs on a standard formula.
Transition costs. Transition costs include all of the costs incurred by a government as it
shifts a service to an outside contractor. These transition costs may include the various
personnel related costs related to laying off employees, including unemployment
compensation, accrued vacation benefits, and severance pay. They may also include the
preparation of government facilities and equipment for use by an outside contractor.
Alternatively, these assets might be sold or otherwise disposed of, resulting in a positive
or negative net salvage value. If the assets are rented, an early termination of the lease
may create additional costs.
Revenues from Outsourcing: Any additional revenues that a government collects as a
result of outsourcing should be subtracted from the costs of outsourcing. In some cases, a
decision to outsource a service may result in increased tax and fee revenues from the
contractor. For example, a contractor may pay property taxes on a new facility constructed
within city limits. Another source of revenue is the sale of government assets that are no
longer needed because a vendor uses its own assets to provide the service. For instance, a
government might sell its garbage trucks if a vendor uses its own vehicles. Care should be
taken to include only the additional revenues that are the result of outsourcing.
Step 4: Compare the cost savings from outsourcing to the costs incurred. The final step in
a make-versus-buy cost analysis is to calculate the difference between the costs saved by
outsourcing a service and the costs incurred. If the costs saved are significantly greater
than the costs incurred, then outsourcing may make financial sense.

The final result of a cost analysis is often based on assumptions that have a fair degree of
uncertainty. As a countermeasure, it is prudent to conduct a sensitivity analysis, which
tests the sensitivity of the final result to changes in the underlying assumptions. There are
three main methods for performing a sensitivity analysis. One method is to recalculate
the result under pessimistic, expected, and optimistic scenarios. A second method is to
recalculate the result many times by testing each assumption over a wide range of values.
A third method is to calculate a probability distribution for the result of an analysis. To
address the uncertainty inherent in any cost analysis, governments sometimes require
that the cost savings from outsourcing exceed the cost of providing the service in-house by
a certain margin. For example, the State of Texas and the federal government use a 10
percent threshold.

There are many non-financial costs and benefits that are difficult to quantify in this type of
analysis but that should be considered nonetheless. For example, there may be a significant
difference in the quality of the service provided by a government and the quality of the
service provided by a private contractor. Underutilised facilities, labour, and equipment
during the transition period may also entail opportunity costs to the government. And
outsourcing may reduce a government’s ability to use the service to carry out policy
goals. On the positive side, shifting a service to a contractor also transfers liability and
other risks to the contractor (even though these risks are likely built into the contract
price). Governments are developing increasingly sophisticated ways of handling these
issues, such as requiring providers to return a percentage of their profits to non-profit
organisations in the community.
Contd...

104 LOVELY PROFESSIONAL UNIVERSITY