1. Recommend A Course Of Action In Outsourcing And Keep Or Replace Decisions © Dale R. Geiger 20111

2. What will influence your decision? Two cars: same model, same price, same engine, same features and accessories, same financing © Dale R. Geiger 20112

3. Terminal Learning Objective Task: Recommend A Course Of Action In Outsourcing And Keep Or Replace Decisions. Condition: You are a cost advisor technician with access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors. Standard: With at least 80% accuracy: Explain relevant costs Identify relevant costs in an outsourcing decision Identify relevant costs in a keep-or-replace decision © Dale R. Geiger 20113

4. What is Relevant? Synonyms for relevant: pertinent, applicable, related, appropriate, significant, important We have access to more information than ever Not every piece of information is pertinent, applicable, or related to a decision Example: fuel economy on new car models is not pertinent to a decision about whether to pursue your Master’s degree © Dale R. Geiger 20114

5. What is Relevant? Some pieces of information can be easily dismissed as unrelated or irrelevant Other times it is more difficult to determine what is appropriate, significant, or important to the decision Especially when the information is printed on an official report from the accounting system Remember that the accounting system measures according to external requirements © Dale R. Geiger 20115

6. What is Relevant? Relevant costs Relevant costs are those costs that change as a result of a decision Identify the decision at hand Choice between two Courses of Action (COA) Frequently one of the options is status quo Identify related costs Which costs are the same for both courses of action? Which will change? © Dale R. Geiger 20116

7. Cost Definitions Acquisition cost Acquisition cost – all costs related to purchasing an asset and placing it into service Operating cost Operating cost – all costs related to operating an asset Opportunity cost Opportunity cost – the value of what is given up when choosing a particular course of action Sunk cost Sunk cost – costs incurred in the past that cannot be recovered Incremental cost Incremental cost – the additional cost incurred as the result of a decision © Dale R. Geiger 20117

8. Cost Definitions Avoidable cost Avoidable cost – cost we currently incur that would be eliminated or avoided by choosing another course of action Unavoidable cost Unavoidable cost – cost we currently incur that would NOT be eliminated or avoided by choosing another course of action © Dale R. Geiger 20118

9. Classic Relevant Cost Problems Outsourcing Outsourcing – Should we provide this service in-house or purchase from a contractor? Keep or replace Keep or replace – Should we keep the equipment we have or replace with more efficient equipment? These are the two most applicable to government entities © Dale R. Geiger 20119

10. Classic Relevant Cost Problems Additional business at reduced price Additional business at reduced price – Should we accept or reject additional business at a reduced price? Scrap or re-work Scrap or re-work – Should we invest additional resources to bring the item up to standards or cut our losses? While less common, these also have government applications © Dale R. Geiger 201110

11. A Template for Organizing the Data Based on the Statement of Activities ItemCOA #1COA #2Δ Revenue or Benefit Revenue COA #1 Revenue COA #2 #2 - #1 Related Cost A Cost A from COA #1 Cost A from COA #2 #2 - #1 Related Cost B Cost B from COA #1 Cost B from COA #2 #2 - #1 Net Change (Rev – Cost) Rev – Costs #2 - #1 © Dale R. Geiger 201111

12. A Template for Organizing the Data Based on the Statement of Activities ItemCOA #1COA #2Δ Revenue or Benefit Revenue COA #1 Revenue COA #2 #2 - #1 Related Cost A Cost A from COA #1 Cost A from COA #2 #2 - #1 Related Cost B Cost B from COA #1 Cost B from COA #2 #2 - #1 Net Change (Rev – Cost) Rev – Costs #2 - #1 COA #1 may be the status quo © Dale R. Geiger 201112

13. A Template for Organizing the Data Based on the Statement of Activities ItemCOA #1COA #2Δ Revenue or Benefit Revenue COA #1 Revenue COA #2 #2 - #1 Related Cost A Cost A from COA #1 Cost A from COA #2 #2 - #1 Related Cost B Cost B from COA #1 Cost B from COA #2 #2 - #1 Net Change (Rev – Cost) Rev – Costs #2 - #1 Define revenues or quantifiable benefits from each COA © Dale R. Geiger 201113

14. A Template for Organizing the Data Based on the Statement of Activities ItemCOA #1COA #2Δ Revenue or Benefit Revenue COA #1 Revenue COA #2 #2 - #1 Related Cost A Cost A from COA #1 Cost A from COA #2 #2 - #1 Related Cost B Cost B from COA #1 Cost B from COA #2 #2 - #1 Net Change (Rev – Cost) Rev – Costs #2 - #1 Express Δ as Favorable or (Unfavorable) © Dale R. Geiger 201114

15. A Template for Organizing the Data Based on the Statement of Activities ItemCOA #1COA #2Δ Revenue or Benefit Revenue COA #1 Revenue COA #2 #2 - #1 Related Cost A Cost A from COA #1 Cost A from COA #2 #2 - #1 Related Cost B Cost B from COA #1 Cost B from COA #2 #2 - #1 Net Change (Rev – Cost) Rev – Costs #2 - #1 If the item is the same for COA #1 and COA #2 the Δ will be -0- indicating the item is irrelevant to the decision © Dale R. Geiger 201115

16. Check on Learning How are relevant costs defined? How does the table format help to identify irrelevant costs? © Dale R. Geiger 201116

17. Outsourcing Decision: Outsource HR function for $200,000 per year or keep in-house? Direct labor cost = four employees @ $50,000 per employee annually Two would be laid off, two would be transferred to another command Unemployment taxes would increase $10,000 per year due to the layoffs Facilities and equipment cost = $35,000 per year Would remain idle Other operating costs = $15,000 per year Would be eliminated © Dale R. Geiger 201117

18. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201118

19. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201119

20. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201120

21. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201121

22. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201122

23. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201123

24. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201124

25. Outsourcing ItemIn-houseOutsourceΔ Revenue or Benefit-0- Direct labor$200,000-0-$200,000 Cost of HR contract-0-$200,000(200,000) Unemployment tax-0-10,000(10,000) Facilities/Equipment35,000 -0- Other operating cost15,000-0-15,000 Net Change-250,000-245,0005,000 © Dale R. Geiger 201125

26. Outsourcing Conclusions Going strictly by the numbers, we would save $5,000 by outsourcing What else should we consider? Are there non-quantifiable benefits from keeping the function in-house? From outsourcing? What if the cost of facilities and equipment increases? Would that change our decision? © Dale R. Geiger 201126

27. Check on Learning Which costs are irrelevant in outsourcing decisions? How are unfavorable deltas identified? © Dale R. Geiger 201127

28. Keep or Replace Your command recently purchased a machine for $50,000. The annual operating cost of the machine is $100,000. An alternative machine to perform the same function has just become available. The new machine costs $70,000 and costs $75,000 per year to operate. We could sell the “old” machine today for $10,000 salvage. Either machine would have a useful life of three years from today, and would produce no revenues. © Dale R. Geiger 201128

29. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201129

30. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old machine (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201130

31. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201131

32. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201132

33. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201133

34. Keep or Replace Decision: Replace Old Machine with More Efficient New Machine? ItemKeepReplaceΔ Salvage of old (benefit) -0-$10,000 Cost of Old (Sunk)$50,00050,000-0- Cost of New-0-70,000(70,000) Operating Costs 3 yrs300,000225,00075,000 Net Change-350,000-335,00015,000 © Dale R. Geiger 201134

35. Keep or Replace Conclusions Replacing the “old” machine will save $15,000 over the three-year period What else should be considered? Any qualitative factors? What if the projected operating costs of the new machine are overly optimistic? What if the actual operating costs are $80,000 per year? $85,000? How would that change our decision? © Dale R. Geiger 201135

36. Check on Learning Which costs are always irrelevant in keep or replace decisions? © Dale R. Geiger 201136

37. Additional Business, Reduced Price The dining hall can serve 200 for breakfast, but averages only 40 on weekends. Daily fixed costs for the morning shift (three employees for four hours, plus cost of facilities) are $500, and variable costs are $2 per breakfast. The regular price for breakfast is $5. A local community service group would like to use the dining hall on Sunday mornings for their meetings. They would pay $3 per person for breakfast. Average attendance at meetings is 75. © Dale R. Geiger 201137

38. Additional Business, Reduced Price ItemStatus Quo With Additional Δ Breakfast sales 40 @ $5 $200 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 80 115 @ $2 230 (150) Fixed Costs500 -0- Net Change-380-30575 © Dale R. Geiger 201138

39. Additional Business, Reduced Price ItemStatus Quo With Additional Δ Breakfast sales 40 @ $5 $200 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 80 115 @ $2 230 (150) Fixed Costs500 -0- Net Change-380-30575 © Dale R. Geiger 201139

40. Additional Business, Reduced Price ItemStatus Quo With Additional Δ Breakfast sales 40 @ $5 $200 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 80 115 @ $2 230 (150) Fixed Costs500 -0- Net Change-380-30575 © Dale R. Geiger 201140

41. Additional Business, Reduced Price ItemStatus Quo With Additional Δ Breakfast sales 40 @ $5 $200 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 80 115 @ $2 230 (150) Fixed Costs500 -0- Net Change-380-30575 © Dale R. Geiger 201141

42. Additional Business, Reduced Price ItemStatus Quo With Additional Δ Breakfast sales 40 @ $5 $200 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 80 115 @ $2 230 (150) Fixed Costs500 -0- Net Change-380-30575 © Dale R. Geiger 201142

43. Assumptions: Excess capacity exists Proposed business will not detract from regular business Rules of thumb: As long as incremental revenue exceeds incremental cost, additional business is desirable Fixed costs are irrelevant Additional Business, Reduced Price © Dale R. Geiger 201143

44. Additional Business, Reduced Price What else should the dining hall management consider? © Dale R. Geiger 201144

45. Should we sell an inferior product as scrap or invest the necessary resources to make the product salable? This has application to military in the area of training Should we discharge individuals who fail basic training or re-train? Scrap or Rework © Dale R. Geiger 201145

46. Discharge or Re-train ItemDischargeRe-trainΔ Benefit of trained soldier -0-XX Cost of Basic TrainingYY-0- Cost of Re-training-0-Z(Z) Net Change-YX – Y – ZX – Z If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable. © Dale R. Geiger 201146

47. Discharge or Re-train ItemDischargeRe-trainΔ Benefit of trained soldier -0-XX Cost of Basic TrainingYY-0- Cost of Re-training-0-Z(Z) Net Change-YX – Y – ZX – Z If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable. Cost of Basic training is a Sunk Cost and therefore irrelevant © Dale R. Geiger 201147

48. Check on Learning Which costs are irrelevant in deciding whether to accept additional business at a reduced price? What is the rule of thumb? © Dale R. Geiger 201148

49. Practical Exercises © Dale R. Geiger 201149