To Outsource or Not to Outsource: a Cost Accounting Decision

In cost accounting, outsourcing is defined as purchasing a good or service from an outside vendor rather than producing the good or service in-house. It’s also referred to as a make versus buy decision.

A decision to outsource certainly considers reducing costs as a goal. If you can get the same (or virtually the same) product or service for less than it costs in-house, why not? So part of your analysis is reviewing costs, and you focus on relevant costs.

There’s more to your outsourcing decision than just costs. You also must consider what you’ll be giving up by losing some control over the goods and services. Think about the quality. Assume you create quality items with few flaws. Is the outsourced item just as good?

Anything you outsource should be delivered on time, just as it is when you make a product in-house. That means that the company you hire will need enough time, staff, and capacity to give you timely delivery.

The company taking over the process should also maintain confidentiality.

Here are two tables you can use to make an outsourcing decision. In this case your product is towels. The first is the “make” decision table. It shows the cost to continue making the towels in-house. The second is the “buy” decision table. It assumes a purchase price from a supplier, who makes the towels. You’ll then add some finishing stitching and your company label. At that point, the towels will be ready for sale.

“Make” Decision – Continue Production
Units Produced: 40,000 Per Unit Total
Variable costs
Direct material $2.00 $80,000
Direct labor $1.00 $40,000
Variable factory overhead $0.50 $20,000
Shipping and handling $0.25 $10,000
Sale commissions $1.00 $40,000
Total variable costs $4.75 $190,000
Fixed costs, salary and benefits $60,000
Other fixed overhead $100,000
Total fixed costs $160,000
Total costs $350,000
The first table shows some variable costs such as material, labor, and overhead. You also see shipping, handling, and sales commissions. These are all the costs to make the product, package and ship it, and sell it (sales commissions).

Your company incurs other fixed overhead, including depreciation in building and equipment, insurance premiums, and office costs. Finally, you incur $60,000 in fixed salary and benefits for a production manager, whose sole role is to manage your towel production during the year.

The variable labor costs are for production workers. These employees are paid on an hourly basis, and their time is directly related to a unit of product. It’s a direct cost and a separate expense from the production manager. The production manager’s time can’t be traced to an individual unit of product and is fixed.

So the first table shows where you stand if you continue to produce the towels yourself. Then something interesting happens: A supplier offers to produce towels for you. Use the supplier’s information to create a second table.

“Buy” Decision — Outsource Production
Units Produced: 40,000 Per Unit Total
Variable costs
Direct material $0 $0
Direct labor $0 $0
Variable factory overhead $0 $0
Purchase cost of towels – supplier $3.80 $152,000
Shipping and handling $0.25 $10,000
Sales commissions $1.00 $40,000
Total variable costs $5.05 $202,000
Fixed costs, salary and benefits $0
Other fixed overhead $100,000
Total fixed costs $100,000
Total costs $302,000

Say what? You save $48,000 ($350,000 versus $302,000 cost) by outsourcing. As you scan down the second table from top to bottom, here’s what you find:

  • Production-related variable costs (materials, labor, and overhead) are eliminated. In their place, you see “Purchase cost of towels – supplier.” That’s what the supplier charges to produce the product.

  • Distribution costs (shipping, handling, and sales commissions) don’t change. Your company will still perform those tasks and incur the costs.

  • Other fixed overhead costs (depreciation, insurance premiums, and so forth) remain. Important point: When you consider outsourcing, some fixed costs cannot be eliminated. By definition, they’re fixed, and your company must continue to pay them.

  • There’s one final cost you can eliminate. Outsourcing assumes that you no longer produce the product. That means you don’t need the production-manager position. That $60,000 fixed salary and benefit cost is eliminated. Because the outsourcing cost total is less than keeping production in-house, you should outsource.

These tables show both relevant and irrelevant costs. You made your decision based on relevant costs — those that changed. Eliminating the variable production cost and the production-manager position saved money. The tables include all costs, so you can envision the entire process.

If you want to be able to live with yourself — and in your community — be very careful of creating a negative externality. In economics, an externality is a cost or benefit that isn’t transmitted by prices. A negative externality is a cost that the creator of a problem (you) doesn’t bear. “Nobody” pays for it, except that everyone pays for it. You could call it “playing for free.”

For example, if you lay off the production manager, he may go on food stamps, which everyone pays for. He may not be able to pay property taxes, which pays for the area schools. Further, the outsourcing company may not pay a living wage or health benefits. Does the deal seem so good now?

It may be that your best financial decision is to produce at a loss. On the surface, that sounds like a bad decision, but it might make sense if it allows you to pay for a fixed cost that you can’t eliminate easily.

Assume you’re committed to make payment on a building lease. You signed a contract, which runs for two more years. You use the building for production. Your analysis indicates that you’ll lose money if you keep producing. However, if you stop producing, you still have to pay that pesky lease payment. (You may want to use a stronger word than pesky.)

You have a choice. You can shut down production and lose the revenue — and still have to pay on the lease, or you produce at a loss. At the least, that generates some revenue to pay the lease. If the loss on production is less than the lease payment, keep producing. You’ll lose less money.

Now, no one wants to tell people, “Business is great! I’m losing less money!” However, it may be the right decision. It allows you to cover at least some of the fixed cost. It’s a short-term solution until you can get out of the fixed cost commitment. At that point, you can shut down production altogether.

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