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.

The cost components of work-in-process and inventory goods will inevitably include some labor. However, the proportion of labor in the total cost mix has dropped markedly over the years, with material and overhead costs now predominating.

Nonetheless, the costing reports the accounting staff has traditionally generated are mostly concerned with labor. Examples of these reports are those detailing overtime, comparing actual to standard labor rates or usage, and labor efficiency. By comparison, the reports concerned with the materials expense typically cover only scrap rates and purchase price variances, while many companies have no reporting for overhead costs at all. Hence, most accounting departments are misallocating their time in reporting on the smallest component of product costs.

How To Address This Issue?

The best way that addresses this problem is one of the easiest to implement—simply stop reporting on labor variances. The accounting staff will have more time to spend on reports concerning costs that make up a larger proportion of product costs. The problem with this best practice is the remarkable uproar it frequently incites, especially on the part of traditional production managers who were raised on the concept of tight control over labor costs.

Thus, the best way to implement this item is to carefully educate the production staff on the following points:

Direct Labor Is Really a Fixed Cost

In many manufacturing situations, the direct labor staff cannot be sent home the moment there is no work left to do. Instead, a company must think about retaining them since they are trained and more efficient than other people who might be brought in off the street. Accordingly, it makes a great deal of sense to guarantee regular working hours to the direct labor staff (within reason). By doing so, it becomes apparent that direct labor is not a variable cost at all and requires much less detailed investigation and reporting work for the accounting staff.

Other Reports Are More Valuable

If the accounting department only has enough resources to issue a fixed number of reports, there is a good argument for eliminating the least useful ones (labor reporting) in favor of ones involving more costs, such as materials and overhead. One can reinforce this argument by formulating trial report layouts for new reports that will replace the labor reports.

Target Costing is The Real Area Of Concern

Many studies have shown that costs are not that variable once a product design is released to the factory floor. Instead, the primary area in which costs can truly be impacted is during the product design.  A strong argument in this area, especially if combined with visits to other companies that have installed target costing, will go a long way toward convincing management on this point. If production management can be convinced that these three points are accurate, it becomes much easier to eliminate labor variance reporting, either completely or in part.

The only situation in which this best practice should not be implemented is one where labor costs still make up the majority of product costs (an increasingly rare situation) and where those costs are variable. If labor costs are highly fixed in nature, there is not much point in continuing to issue reports showing that the costs have not changed from period to period.

When the accounting department issues financial statements, one of the largest expenses listed on it is the material cost (at least in a manufacturing environment). Unless they conduct a monthly physical inventory count, the accounting staff must rely on the word of the logistics department in assuming that the month end inventory listed on the books is the correct amount. If it is not, the financial statements can be off by a significant amount. The core document used by the logistics department that drives the accuracy of the inventory is the “Bill Of Material (BOM)”.

This is a listing of the components that go into a product. If it is incorrect, the parts assumed to be in a product will be incorrect, which means that product costs will be wrong, too. This problem has the greatest impact in a back flushing environment, where the bills of material determine how many materials are used to produce a product. Thus, the accuracy of the bills of material has a major impact on the accuracy of the financial statements.

The solution is to follow an ongoing program of auditing bills of material. By doing so, errors are flushed out of the bills, resulting in better inventory quantity data, which in turn results in more accurate financial statements. The best way to implement bill audits is to tie them to the production schedule, so that any products scheduled to be manufactured in the near future are reviewed the most frequently. This focuses attention on those bills with the highest usage, though it is still necessary to review the bills of less frequently used products from time to time. The review can be conducted by the engineering staff, the production scheduler, the warehouse staff, and the production staff. The reason for using so many people is that they all have input into the process. The engineering staff has the best overall knowledge of the product, while the production scheduler is the most aware of production shortages caused by problems with the bills, and the warehouse staff sees components returned to the warehouse that were listed in the bills but not actually used; the production staff must assemble products and knows from practical experience which bills are inaccurate. Thus, a variety of people (preferably all of them) can influence the bill of material review process.

Measuring a bill of material includes several steps. One is to ensure that the correct part quantities are listed. Another is to verify that parts should be included in the product at all. Yet another is that the correct subassemblies roll up into the final product. If any of these items are incorrect, a bill of material should be listed as incorrect in total. For a large bill with many components, this means that it will almost certainly be listed as incorrect when it is first reviewed, with rapid improvement as corrections are made. The target that a company should shoot for when reviewing bills of material is a minimum accuracy level of 99 percent. At this level, any errors will have a minimal impact on accuracy, cost of the inventory, and cost of goods sold.

If a controller can effectively work with the engineering, production, and logistics staffs to create a reliable bill of material review system, the result is a much more accurate costing system.