Outsourcing Decisions Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 21

The Outsourcing/Insourcing Decision  Used to assess whether a product or service should be generated internally or purchased from an outside supplier  Outsourcing services such as payroll, IT, and consulting are becoming more common  Also called Make or Buy decisions  Enables a company to reduce costs and/or benefit from supplier efficiencies 2

What is Incremental & What is Not? Not relevant  Sunk costs  Allocated fixed costs Nonexistent  Revenues 3 Incremental Costs The additional costs incurred from outsourcing Variable costs Avoidable fixed costs Incremental Cost Savings A reduction of costs due to outsourcing Opportunity Costs Costs or benefits that are given up as the result of selecting a different alternative

How to Make Outsourcing Decisions Use qualitative characteristics to assess 4 If incremental cost savings < incremental costs Continue to make internally, unless qualitative characteristics impact the decision If incremental cost savings > incremental costs Ousource, unless qualitative characteristics impact the decision If incremental cost savings = incremental costs

Qualitative Factors Affecting Outsourcing Decisions  Quality control  Timeliness of obtaining the service or product being outsourced  Termination of employees  Impact on employee morale of the remaining work force  Community impact due to reduction of jobs available  Impact on suppliers 5 Key Qualitative Factors

Outsourcing Example DP manufactures cart motors currently used in one of its products. An outside supplier has offered to provide the 1,000 motors needed at a cost of $23 each. The motor department’s supervisor will be terminated if the motors are outsourced. The equipment used to manufacture motors has no resale value. Fixed factory overhead is allocated equally to each motor produced. The following costs are incurred to produce 1,000 motors: 6 Direct materials $9,000 Direct labor 5,000 Variable overhead 2,000 Depreciation of equipment 3,000 Supervisor's salary 4,500 Fixed factory overhead 10,000 Total costs $33,500 Depreciation and the fixed factory overhead are not relevant.

Incremental Approach Solution Should DP outsource? Only relevant costs are listed on the incremental analysis. 7 Based solely on quantitative analysis, no. Outsourcing will cause profit to drop by $2,500. Incremental cost to buy (1,000 x $23) ($23,000) Incremental cost savings: Direct materials 9,000 Direct labor 5,000 Variable overhead 2,000 Supervisor’s salary 4,500 Incremental decrease in profit if outsourced ($2,500)

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