More often than not, when a business function becomes a distraction from an organization’s core business, entrepreneurs and business managers often ask the question: “Should we outsource it?”
This is a question that mostly applies to your non-core business functions such as data entry, email handling, document processing, IT services, accounting, payroll etc.
However, making the right decision can yield significant benefits in terms of increased productivity and cost saving. Likewise, a wrong decision can put your business at a competitive disadvantage.
Hence, when you need to make a decision on whether or not to outsource, it is very important to consider the pros and cons of outsourcing versus choosing to keep the function in-house.
While there are tools that help simplify how you can make a case for outsourcing, performing a cost analysis is a best “first step”.
At its simplest form, think of your outsourcing cost analysis as; if you can get the same (or virtually the same) product or service for less than it costs in-house, then why not? However, remember that there’s more to outsourcing than cost, you’ll also need to think about the quality of service, timeliness of delivery and confidentiality of business information.
So, how can you determine your outsourcing cost when considering outsourcing a business function?
Differential cost analysis is the key cost concept for evaluating the outsourcing decision. The differential cost analysis shows you how outsourcing will impact your organization’s costs. You should always look at the differential costs instead of comparing the total costs of the status quo to the total costs of outsourcing to an outsourcing partner.
Why differential Cost? This is because by comparing only total costs, you might end up including fixed costs that cannot be avoided by outsourcing and this can give you the false impression that you will incur lesser costs.
Here are 4 steps to help you determine your outsourcing cost using the differential cost concept:
It is important to specify the quality and quantity of the business function that you are considering to outsource and the expected outcomes. This is necessary for you to achieve a fair comparison between what is realizable in-house and the service proposed by external contractors.
If a business function is vaguely or wrongly defined, the in-house costs may be higher (or lower) than the outsourcing costs simply because you may be is doing more (or less) internally than what is documented in the request for proposals to vendors.
After clearly defining the business function that you would like to outsource, the next step is to identify and calculate the costs your organization would avoid if it outsourced that function.
To begin, you need to first itemize all the costs related to the business function to be outsourced, including direct costs (supplies, salaries, equipment, etc.) and indirect costs (administration and internal services).
It is very critical that you do not include costs that have already been incurred and cannot be recovered, known as Sunk Cost. Decision-making based on cost analysis focuses on avoidable future costs, which in this case are costs that can be eliminated by outsourcing to an external contractor.
Next, you need to determine all the in-house costs that could be avoided if the business function was outsourced.
The third step is to calculate the total costs of outsourcing the specific business function. The costs of outsourcing include the contractor’s bid price, contract administration costs, and the transition costs, less any new revenue generated from sales of unneeded supplies, equipment, and furniture.
Your contract administration costs will include all the cost associated with activities necessary to select and manage an outsourcing partner over the life of the contract. For a small business that outsource on platforms like Upwork, peopleperhour etc., this may be subscription fees, wages for a virtual assistant to evaluate bids, and charges to fund your account.
For larger outsourcing projects, these may include the cost associated with reviewing and evaluating the request for proposals, writing and negotiating the contract, processing change orders and amendments to the contract, monitoring and evaluating contractor performance, dealing with disputes, and processing payments to the contractor.
Your transition costs include all of the cost you incur by shifting a business function to an external contractor. These transition costs may include the personnel costs related to laying off employees, including unemployment compensation, and severance pay.
The final step is to calculate the difference between your costs saved from outsourcing and the costs incurred from outsourcing. If your results show that outsourcing can significantly reduce your cost, then your can justify proceeding toward outsourcing.
For better understanding, here are some tables that illustrate a simple differential cost analysis.
In-house Cost Table
|Categories||Costs||In-house cost avoided by outsourcing|
Outsourcing Cost Table
|Contractor bid price||$250,000|
– Unemployment compensations
– Severance pay
– Early termination penalties
|Revenue from sales of unneeded assets||$10,000|
Comparison of Cost Tables
|$600,000||– $295,000||= $305,000|
|In-house costs avoided|
|Total costs of outsourcing||Cost savings of outsourcing|
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