Accounting, Financial, Taxation

A daily question faced by managers is whether the right components and services will be available at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured themselves of service and part availability and quality by controlling all functions internally. However, there is a growing trend toward “outsourcing” (buying) a greater percentage of required materials, components, and services.

This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal production and opportunity costs with purchase cost and assesses the best uses of available facilities. Consideration of an in-source (make) option implies that the company has available capacity for that purpose or has considered the cost of obtaining the necessary capacity. Relevant information for this type of decision includes both quantitative and qualitative factors. Here is lists the top motivations for companies to pursue outsourcing.

Top Ten Reasons to Outsource

1. Reduce and control operating costs.
2. Improve company focus.
3. Gain access to world-class capabilities.
4. Free internal resources for other purposes.
5. Obtain resources not available internally.
6. Accelerate reengineering benefits.
7. Eliminate a function difficult to manage/out of control.
8. Make capital funds available.
9. Share risks.
10. Obtain cash infusion.

Source: The Outsourcing Institute, Survey of Current and Potential Outsourcing End-Users

And below figure presents factors that should be considered in the outsourcing decision. Several of the quantitative factors, such as incremental direct material and direct labor costs per unit, are known with a high degree of certainty. Other factors, such as the variable overhead per unit and the opportunity cost associated with production facilities, must be estimated. The qualitative factors should be evaluated by more than one individual so personal biases do not cloud valid business judgment.

Outsource Decision Considerations

Relevant Quantitative Factors:

1. Incremental production costs for each unit
2. Unit cost of purchasing from outside supplier (price less any discounts available plus shipping, etc.)
3. Number of available suppliers
4. Production capacity available to manufacture components
5. Opportunity costs of using facilities for production rather than for other purposes
6. Amount of space available for storage
7. Costs associated with carrying inventory
8. Increase in throughput generated by buying components

 

Relevant Qualitative Factors:

1. Reliability of supply sources
2. Ability to control quality of inputs purchased from outside
3. Nature of the work to be subcontracted (such as the importance of the part to the whole)
4. Impact on customers and markets
5. Future bargaining position with supplier(s)
6. Perceptions regarding possible future price changes

 

Although companies may gain the best knowledge, experience, and methodology available in a process through outsourcing, they also lose some degree of control. Thus, company management should carefully evaluate the activities to be outsourced. The pyramid shown below is one model for assessing outsourcing risk.

Factors to consider include whether:

(1) a function is considered critical to the organization’s long-term viability (such as product research and development)

(2) the organization is pursuing a core competency relative to this function; or

(3) issues such as product/service quality, time of delivery, flexibility of use, or reliability of supply cannot be resolved to the company’s satisfaction.

Case Example: Outsource Decision

Here is information about inkjet printers produced by Online Computers. The total cost to manufacture one case is $5.50. The company can purchase the case from a chemical products company for $4.30 per unit. Online Computers’ cost accountant is preparing an analysis to determine if the company should continue making the cases or buy them from the outside supplier.

Production of each case requires a cost outlay of $4.10 per unit for materials, labor, and variable overhead. In addition, $0.50 of the fixed overhead is considered direct product cost because it specifically relates to the manufacture of cases.

This $0.50 is an incremental cost since it could be avoided if cases were not produced. The remaining fixed overhead ($0.90) is not relevant to the outsourcing decision. This amount is a common cost incurred because of general production activity, unassociated with the cost object (cases). Therefore, because this portion of the fixed cost would continue under either alternative, it is not relevant.

The relevant cost for the in-source alternative is $4.60—the cost that would be avoided if the product were not made. This amount should be compared to the $4.30 cost quoted by the supplier under the outsource alternative. Each amount is the incremental cost of making and buying, respectively. All else being equal, management should choose to purchase the cases rather than make them, because $0.30 will be saved on each case that is purchased rather than made. Relevant costs are those costs that are avoidable by choosing one decision alternative over another, regardless of whether they are variable or fixed. In an outsourcing decision, variable production costs are relevant. Fixed production costs are relevant if they can be avoided when production is discontinued.

The opportunity cost of the facilities being used by production is also relevant in this decision. If a company chooses to outsource a product component rather than to make it, an alternative purpose may exist for the facilities now being used for manufacturing. If a more profitable alternative is available, management should consider diverting the capacity to this use.

Assume that Online Computers has an opportunity to rent the physical space now used to produce printer cases for $90,000 per year. If the company produces 600,000 cases annually, there is an opportunity cost of $0.15 per unit ($90,000:600,000 cases) from using, rather than renting, the production space. The existence of this cost makes the outsource alternative even more attractive.

The opportunity cost is added to the production cost since the company is foregoing this amount by choosing to make the cases. Sacrificing potential revenue is as much a relevant cost as is the incurrence of expenses.

The next figure shows calculations relating to this decision on both a per-unit and a total cost basis. Under either format, the comparison indicates that there is a $0.45 per-unit advantage to outsourcing over in-sourcing.

Another opportunity cost associated with in-sourcing is the increased plant throughput that is sacrificed to make a component. Assume that case production uses a resource that has been determined to be a bottleneck in the manufacturing plant. Management calculates that plant throughput can be increased by 1 percent per year on all products if the cases are bought rather than made. Assume this increase in throughput would provide an estimated additional annual contribution margin (with no incremental fixed costs) of $210,000. Dividing this amount by the 600,000 cases currently being produced results in a $0.35 per-unit opportunity cost related to manufacturing. When added to the production costs of $4.60, the relevant cost of manufacturing cases becomes $4.95.

Based on the above information (even without the inclusion of the throughput opportunity cost), Online Computers’ cost accountant should inform company management that it is more economical to outsource cases for $4.30 than to manufacture them. This analysis is the typical starting point of the decision process—determining which alternative is preferred based on the quantitative considerations.

Managers then use judgment to assess the decision’s qualitative aspects. Assume that Online Computers’ purchasing agent read in the newspaper that the supplier being considered was in poor financial condition and there was a high probability of a bankruptcy filing. In this case, management would likely decide to in-source rather than outsource the cases from this supplier. In this instance, quantitative analysis supports the purchase of the units, but qualitative considerations suggest this would not be a wise course of action because the stability of the supplying source is questionable.

This additional consideration also indicates that there are many potential long run effects of a theoretically short-run decision. If Online Computers had stopped case production and rented its production facilities to another firm, and the supplier had then gone bankrupt, the company could be faced with high start-up costs to revitalize its case production process. This was essentially the situation faced by Stonyfield Farm, a New Hampshire-based yogurt company. Stonyfield Farm subcontracted its yogurt production, and one day found its supplier bankrupt—creating an inability to fill customer orders. It took Stonyfield two years to acquire the necessary production capacity and regain market strength.

These costs should be referred to as long-run variable costs because, while they do not vary with volume in the short run, they do vary in the long run. As such, they are relevant for long-run decision making.

For example: assume a part or product is manufactured (rather than outsourced) and the company expects demand for that item to increase in the next few years. At a future time, the company may be faced with a need to expand capacity and incur additional “fixed” capacity costs. These long-run costs would, in turn, theoretically cause product costs to increase because of the need to allocate the new overhead to production. To suggest that products made before capacity is added would cost less than those made afterward is a short-run view. The long-run viewpoint would consider both the current and “long-run” variable costs over the product life cycle. However, many firms expect prices charged by their suppliers to change over time and actively engage in cooperative efforts with their suppliers to control costs and reduce prices.

Outsourcing decisions are not confined to manufacturing entities. Many service organizations must also make these decisions. For example, accounting and law firms must decide whether to prepare and present in-house continuing education programs or to outsource such programs to external organizations or consultants.

Private schools must determine whether to have their own buses or use independent contractors. Doctors investigate the differences in cost, quality of results, and convenience to patients between having blood samples drawn and tested in the office or in an independent lab facility. Outsourcing can include product and process design activities, accounting and legal services, utilities, engineering services, and employee health services.

Outsourcing decisions consider the opportunity costs of facilities. If capacity is occupied in one way, it cannot be used at the same time for another purpose. Limited capacity is only one type of scarce resource that managers need to consider when making decisions.

After discussing “interim reporting” in my previous posts, you may want to know about “segmental reporting” as well. So let’s discuss about this a bit. Through this post, I am trying to answer some basic questions may arise around segental reporting.

The financial reporting for business segments is useful in appraising segmental performance, earning prospects, and risk. Segmental reporting may be by industry, foreign geographic area, major customers, and government contracts. The financial statement presentation for segments may appear in the body, footnotes, or separate schedule to the financial statements. Some segmental information is required in interim reports.

An industry segment sells products or renders services to outside customers. Segmental data occur when a company prepares a full set of financial statements (balance sheet, income statement, statement of cash flows, and related footnotes).

Segmental information is shown for each year presented. Accounting principles employed in preparing financial statements should be used for segment information, except that inter-company transactions eliminated in consolidation are included in segmental reporting.

What Are the Requirements of FASB Statement No. 131?

FASB Statement No. 131 (Disclosures about Segments of an Enterprise and Related Information) mandates that the amount reported for each segment item be based on what is used by the ‘‘chief operating decision maker’’ to determine how many resources to assign to a segment and how to evaluate the performance of that segment.

The term chief operating decision maker may apply to the chief executive officer or chief operating officer or to a group of executives. It may also relate to a function and not necessarily to a particular person.

Revenue, gains, expenses, losses, and assets should be allocated to a segment only if the chief operating decision maker takes it into account in measuring a segment’s profitability to formulate a financial or operating decision.

The same applies to allocating to segments eliminations and adjustments applying to the entity’s general-purpose financial statements. Any allocation of financial items to a segment should be rationally based.

In measuring a segment’s profitability or assets, the following points should be disclosed for explanatory reasons:

1. Measurement or valuation basis used.
2. A change in measurement method.
3. Differences in measurements used for the general purpose financial statements compared to the financial data of the segment.
4. A symmetrical allocation, referring to an allocation of depreciation or amortization to a segment without a related allocation to the associated asset.

An operating segment is a distinct revenue-producing component of the business for which internal financial information is generated. Expenses are reported as incurred in that segment. It should be noted that a start-up operation would be considered an operating segment even though revenue is not being earned. The chief operating decision maker periodically reviews an operating segment to analyze performance and to ascertain what and how many resources to allocate to the segment.

What Reconciliation Is Required for Segmental Reporting?

A business need not use the same accounting principles for segmental reporting as that used to prepare the consolidated financial statements. A reconciliation must be made between segmental financial information and general-purpose financial statements. The reconciliation is for revenue, operating profit, and assets. Any differences in measurement approaches between the company as a whole and its segments should be explained. The Controller and the CFO must describe the reasoning and methods in deriving the composition of its operating segments.

What Segments Should Be Reported On?

A segment must be reported if one or more of these conditions are satisfied:

1. Revenue is 10 percent or more of total revenue.
2. Operating income is 10 percent or more of the combined operating profit.
3. Identifiable assets are 10 percent or more of the total identifiable assets.

The factors to be taken into account when determining industry segments are:

1. Nature of the market - Similarity exists in geographic markets serviced or types of customers.
2. Nature of the product - Related products or services have similar purposes or end uses (e.g., similarity in profit margins, risk, and growth).
3. Nature of the production process - Homogeneity exists when there is interchangeable production of sales facilities, labor force, equipment, or service groups.

Reportable segments are determined by:

1. Identifying specific products and services
2. Grouping those products and services by industry line into segments
3. Selecting material segments to the company as a whole

There should be a grouping of products and services by industry lines. A number of approaches exist. However, no one method is appropriate in determining industry segments in every case. In many instances, management judgment determines the industry segment. A starting point in deciding on an industry segment is by profit center. A profit center is a component that sells mostly to outsiders for a profit. When the profit center goes across industry lines, it should be broken down into smaller groups. A company in many industries not accumulating financial information on a segregated basis must disaggregate its operations by industry line.

Although worldwide industry segmentation is recommended, it may not be practical to gather. If foreign operations cannot be disaggregated, the firm should disaggregate domestic activities. Foreign operations should be disaggregated where possible, and the remaining foreign operations should be treated as a single segment.

What Should Be Disclosed?

Disclosures are not required for 90 percent enterprises (e.g., a company that derives 90 percent or more of its revenue, operating profit, and total assets from one segment). In effect, that segment is the business. The dominant industry segment should be identified. Segmental disclosure includes:

1. Allocation method for costs.
2. Capital expenditures.
3. Aggregate depreciation, depletion, and amortization expense.
4. Transfer price used.
5. Unusual items affecting segmental profit.
6. Company’s equity in vertically integrated unconsolidated subsidiaries and equity method investees (Note the geographic location of equity method investees).
7. Effect of an accounting principle change on the operating profit of the reportable segment. (Also include its effect on the company).
8. Material segmental accounting policies not already disclosed in the regular financial statements.
9. Type of products.

What If Consolidation Is Involved?

If a segment includes a purchase method consolidated subsidiary, segmental information is based on the consolidated value of the subsidiary (e.g., fair market value and goodwill recognized) and not on the book values recorded in the subsidiary’s own financial statements.

Segmental information is not required for unconsolidated subsidiaries or other unconsolidated investees. Each subsidiary or investee is subject to the rules of FASB Statement No. 13 that segment information be reported. Some types of typical consolidation eliminations are not eliminated when reporting for segments. For example: revenue of a segment includes inter-segmental sales and sales to unrelated customers. A complete set of financial statements for a foreign investee that is not a subsidiary does not have to disclose segmental information when presented in the same financial report of a primary reporting entity except if the foreign investee’s separately issued statements already disclose the required segmental data.

The income tax provision includes current and deferred taxes (e.g., total tax expense for a nine-month period is shown in the third quarter based on nine months’ income). The tax expense for the three-month period based on three months revenue may also be presented (e.g., third quarter tax expense based on only the third quarter). In computing tax expense, use the estimated annual effective tax rate based on income from continuing operations. If a reliable estimate is not feasible, the actual year-to-date effective tax rate may be used.

At the end of each interim period, a revision of the effective tax rate may be needed using the best estimates of the annual effective tax rate. The projected tax rate includes adjustment for net deferred credits. Adjustments should be considered in deriving the maximum tax benefit for year-to-date figures.

The estimated effective tax rate should incorporate all available tax credits (e.g., foreign tax credit). A change in taxes arising from a new tax law is immediately reflected in the interim period it occurs.

Income statement items after income from continuing operations (e.g., income from discontinued operations, extraordinary items, and cumulative effect of a change in accounting principle) should be presented net of taxes. The tax effect on these unusual line items should be reflected only in the interim period when they actually occur. Prior period adjustments in the retained earnings statement are also shown net of tax.

The tax implication of an interim loss is recognized only when realization of the tax benefit is assured beyond reasonable doubt. If a loss is expected for the remainder of the year, and carry-back is not possible, the tax benefits typically should not be recognized.

The tax benefit of a previous year operating loss carry-forward is recognized as an extraordinary item in each interim period to the extent that income is available to offset the loss carry-forward.