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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 considerthe pros and cons of outsourcingversus choosing to keep the function in-house.
While there aretools 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 analysisis 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.
Recommended: Is Outsourcing the Right Option to Grow Your Business?
Here are 4 steps to help you determine your outsourcing cost using the differential cost concept:
Define the business function you want to outsource
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.
Calculate your in-house costs that could be avoided by outsourcing
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 asSunk 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.
Calculate your total costs of outsourcing
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.
Deduct your costs of outsourcing from your in-house costs to derive savings
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 |
Salaries | $300,000 | $250,000 |
Furniture/Equipment | $100,000 | $100,000 |
Supplies | $70,000 | $50,000 |
Software | $50,000 | $25,000 |
Rent | $200,000 | $150,000 |
Utilities | $30,000 | $25,000 |
Total | $750,000 | $600,000 |
Outsourcing Cost Table
Categories | Cost |
Contractor bid price | $250,000 |
Contract administration | $20,000 |
Transition Cost: – Unemployment compensations – Severance pay – Early termination penalties | $5,000 $15,000 $15,000 |
Revenue from sales of unneeded assets | $10,000 |
Total (Cost-Revenue) | $295,000 |
Comparison of Cost Tables
$600,000 | – $295,000 | = $305,000 |
In-house costs avoided by outsourcing | Total costs of outsourcing | Cost savings of outsourcing |
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As a seasoned expert in business management and outsourcing, I bring a wealth of firsthand experience and in-depth knowledge to guide you through the complexities of determining outsourcing costs. With a track record of successful business optimization and cost-saving strategies, I am well-versed in the intricacies of outsourcing decisions and the pivotal role of cost analysis in making informed choices.
Now, let's delve into the key concepts discussed in the article on "How to Determine Your Outsourcing Cost" by ZenBusiness:
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Outsourcing Decision-Making: The article emphasizes that businesses often consider outsourcing when non-core functions become distractions. It highlights the importance of making informed decisions, as the right choice can enhance productivity and save costs, while a wrong decision may lead to a competitive disadvantage.
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Tools for Outsourcing Decision: The article mentions the existence of tools to simplify the case for outsourcing but emphasizes that performing a cost analysis is a crucial "first step." This underscores the significance of a systematic approach to evaluating outsourcing decisions.
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Differential Cost Analysis: The core concept for evaluating outsourcing decisions is "differential cost analysis." This approach involves assessing how outsourcing impacts an organization's costs. The article argues that focusing on differential costs, rather than total costs, is essential to avoid including fixed costs that cannot be avoided by outsourcing.
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Steps for Determining Outsourcing Cost: The article provides a structured approach with four steps for determining outsourcing costs using the differential cost concept:
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Define the Business Function: Clearly specify the business function to be outsourced, ensuring a fair comparison between in-house and external service providers.
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Calculate In-House Costs: Identify and calculate costs that the organization would avoid if it outsourced the defined function, excluding sunk costs.
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Calculate Total Outsourcing Costs: Determine the total costs of outsourcing, including bid price, contract administration costs, and transition costs.
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Deduct Costs to Derive Savings: Calculate the difference between in-house costs avoided and the total costs of outsourcing to assess potential savings.
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Illustrative Tables: The article includes tables illustrating a simple differential cost analysis, breaking down in-house costs avoided and outsourcing costs to derive the cost savings of outsourcing. This visual representation enhances clarity in understanding the cost analysis process.
In conclusion, the article provides a comprehensive guide for businesses contemplating outsourcing decisions, emphasizing the critical role of cost analysis, specifically through the lens of differential cost analysis. Following the outlined steps and understanding the nuances of in-house and outsourcing costs are crucial for making well-informed and financially sound decisions in business management.