Page 95 - DCOM206_COST_ACCOUNTING_II

Cost Accounting – II

Notes


Caselet Cost Analysis for a Make-versus-Buy Decision

n example will illustrate how to perform a cost analysis for a make-versus-buy
decision. Suppose the City of Greenville is considering outsourcing lawn and
Agrounds maintenance to a private firm. As a first step toward determining if
outsourcing lawn and grounds maintenance makes financial sense, the city defines this
particular service. Lawn and grounds service is provided by the city’s Public Works
Department, which maintains 200 acres of developed parkland.

Next, the city calculates the total costs that would be avoided or saved by outsourcing
lawn and grounds maintenance. To determine the costs that would be saved by outsourcing,
the full cost of the service is itemised, including all of the direct and indirect costs. The top
portion of Exhibit 1 shows how this would look over a five-year period. The city would be
able to avoid several of the costs in the second column if the service were outsourced.
About $400,000 in personnel costs would be avoided by virtue of a combination of layoffs
of seasonal employees and a promise from the vendor to hire 30 percent of the city’s
employees. The remaining employees would be reassigned to other tasks. The city would
continue to incur insurance costs for lawn maintenance equipment until the insurance
contract terminates after the first year. Administrative overhead costs often cannot be
avoided (at least in the short run) because they are generated in other departments, such as
finance and human resources that would likely remain fully staffed even if the service
were outsourced. The total savings for each year are discounted to their present value. The
third step is to calculate the total costs of outsourcing lawn and grounds maintenance. The
bottom portion of Exhibit 1 shows how this would look over a five-year period. The costs
of outsourcing include the contractor’s bid, the government’s contract administration
costs, and the government’s transition costs, less the additional revenue generated from
outsourcing. The total costs for each year are discounted to their present value. Only the
new costs associated with outsourcing the service are included in the analysis.

Exhibit 1: Illustrative Make-versus-Buy Analysis

Contd...

90 LOVELY PROFESSIONAL UNIVERSITY