Hazards When Analyzing Costs for Manufacturing Outsourcing Decisions

Outsourcing decisions of all sizes place a premium on the availability of highly responsive cost information that reflects causal relationships of the operations and resources impacted.

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When this type of cost information is not available (which is a common occurrence), a common alternative is a situational business analysis of traditional financial statement accounting information.

The problem with relying on situational analyses is that they rarely are done for small- to mid-range decisions because they take too long. Additionally, special analyses are subject to substantial variation based on the skill of the analyst.

A highly responsive cost system that reflects operations continuously generates the needed information, greatly simplifying the analysis. This article focuses on the small- to mid-size outsourcing decisions since they typically suffer the most significant distortion from traditional accounting information.

The key question when analyzing costs for outsourcing decisions is: What costs will change as a result of the decision to outsource?  This is a much more complex question than it appears. 

For example, if you are considering outsourcing a component that has overhead assigned to it, each element included in the overhead should be evaluated to determine if it will actually stop being incurred. In traditional standard cost systems, overhead costs may not be assigned to components, only final products.  This example points out two significant problems. First, what is meant by “cost”?  Overhead is an abstraction that aggregates resources and processes. Second, cost information must reflect causal relationships and the capacities of resources to be accurately evaluated.

What are costs?
Costs are a business result from the acquisition and use of resources. So the first task in analyzing an outsourcing decision is to determine which resources will become idle (people, machines or unnecessary purchased services and raw materials).

Idle resources must then be evaluated for divisibility. This means the idle resource can be eliminated or the idle capacity used for another purpose valuable to the organization. Often partially idle resources cannot be eliminated or repurposed and will not result in a cost reduction.

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Financial analyses done with traditionally generated calculations of fixed and variable costs often miss the mark since costs are only considered variable or fixed in relation to a final product or service.  A decision involving a particular maintenance activity or component may not have this data.

Advanced costing systems apply the concept of responsiveness in tracing fixed and variable costs.  Responsiveness traces the consumption of resources through the value chain in quantities and financial terms.  It accurately represents how the nature of cost and consumption change as resources are consumed by other resources, processes and, eventually, final products. 

For example, electricity is a variable cost when purchased from the utility company; however, when the electricity is used to cool a refrigerated storage space, it becomes a fixed cost of operating the storage space unless the need for the storage space is completely eliminated.

The key to effectively determining what costs will change is to ensure the cost model used is built to reflect the causal relationships of all the company’s resources at each step in the productive process. 

While a situational cost analysis created for a one-time decision can accomplish this, the most consistent way to insure all decisions are more effective is to build a robust cost model and supporting system for decision support. Without such a costing system, small and midsize decisions will suffer from the limitations of traditional financial accounting systems. Every special analysis will not only be a new special analysis but will require discussion or argument about why it differs from the financial accounting cost system.

Larry White, CMA, CPA, CGFM  lwhite@rcainstitute.org, is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org).

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