Recommend a Course of Action in Outsourcing ( Relevant Cost)

1. Recommend a Course of Action in Outsourcing (Relevant Cost) Intermediate Cost Analysis and Management

2. What will influence your decision? • Two cars: same model, same price, same engine, same features and accessories, same financing

3. Terminal Learning Objective • Task: Recommend A Course of Action in Outsourcing and Keep or Replace Decisions. • Condition: You are training to become an ACE with access to ICAM course handouts, readings, and spreadsheet tools 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

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

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

6. What is Relevant? • 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?

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

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

9. Classic Relevant Cost Problems • Outsourcing – Should we provide this service in-house or purchase from a contractor? • 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

10. Classic Relevant Cost Problems • Additional business at reduced price – Should we accept or reject additional business at a reduced price? • 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

11. A Template for Organizing the Data • Based on the Statement of Activities

12. A Template for Organizing the Data • Based on the Statement of Activities COA #1 may be the status quo

13. A Template for Organizing the Data • Based on the Statement of Activities Define revenues or quantifiable benefits from each COA

14. A Template for Organizing the Data • Based on the Statement of Activities Express Δ as Favorable or (Unfavorable)

15. A Template for Organizing the Data • Based on the Statement of Activities 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

16. Learning Check • How are relevant costs defined? • How does the table format help to identify irrelevant costs?

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

18. Outsourcing

19. Outsourcing

20. Outsourcing

21. Outsourcing

22. Outsourcing

23. Outsourcing

24. Outsourcing

25. Outsourcing

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?

27. Learning Check • Which costs are irrelevant in outsourcing decisions? • How are unfavorable deltas identified?

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.

29. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

30. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

31. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

32. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

33. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

34. Keep or Replace • Decision: Replace Old Machine with More Efficient New Machine?

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?

36. Learning Check • Which costs are always irrelevant in keep or replace decisions?

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.

38. Additional Business, Reduced Price

39. Additional Business, Reduced Price

40. Additional Business, Reduced Price

41. Additional Business, Reduced Price

42. Additional Business, Reduced Price

43. Additional Business, Reduced Price • 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

44. Additional Business, Reduced Price • What else should the dining hall management consider?

45. Scrap or Rework • 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?

46. Discharge or Re-train If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable.

47. Discharge or Re-train Cost of Basic training is a Sunk Cost and therefore irrelevant If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable.

48. Learning Check • Which costs are irrelevant in deciding whether to accept additional business at a reduced price? • What is the rule of thumb?

49. Practical Exercises