Outsourcing vs. in-house processing - a cost-based analysis

Ranganatha Maligi, Consultant, Capco

Although reduction in operating costs is not necessarily the first reason to outsource, practically every such decision should result in cost savings. Yet some companies (or departments within companies) actually resist outsourcing, believing that they can do it better and more cheaply in-house. In a few cases, this may be true. But in most, this thought process is not based on a complete and accurate analysis of the facts.

Direct costs:
When considering outsourcing parts, or the entirety, of any business process the following associated costs need to be taken into account: salaries, benefits, training/education, specialized software, travel, phone charges, depreciation/amortization, mail costs and postage, MIS support, office supplies, equipment, management time, information costs, and occupancy charges. It is essential to understand these costs in the context of the activities which make up the function. Unfortunately, most organizations capture costs on a cost element basis (salaries, benefits, rent, and depreciation) rather than on a process or activity basis. Without good knowledge of the process cost, it is not possible to compare the value of an external provider of the service.

The process of determining activity-based costs involves five steps:

1. Identifying all activities which make up the function.
2. Grouping similar activities (10-15 with no one activity representing more than 20% of the total cost).
3. Determining the activity drivers. For example, labor (% of people's time used by an activity) and non-labor drivers (% of office space utilized or number of machine hours required for the activity).
4. Determining the costs of the activity drivers.
5. Producing the list of costs related to each activity. For a truly complete understanding, anticipated future costs of maintaining the process in-house also need to be calculated.

Indirect costs:
Besides the direct costs involved, there are other, cost-related benefits of outsourcing to be considered.

Turn fixed costs into variable costs - For most companies, employee related costs and the associated overhead are relatively fixed, regardless of product or service demand. This can be very costly during slow sales periods. Outsourcing turns these fixed costs into variable costs, as the providers have greater economies of scale and thus can price for variable demand.

Reduce investments in assets - There are current expenses that benefit future years, like investments in training, other employee development, and transformation/re-engineering programs. Outsourcing effectively transfers these ongoing investments to the provider.

Improve cash flows - Future growth is always dependent upon adequate cash flows. Outsourcing some or all of the receivable management functions can assure a company of tying receivable resources directly to sales volumes. Companies experiencing strong growth cannot afford to have cash tied up in receivables while new credit and collection staff take 3-6 months getting up to speed.

Once you have determined your process costs, comparison to industry benchmarks can give you an idea about how you are doing in relation to other companies, and how the provider's quotations stack up. A recent article on BPO quotes a Fortune 500 firm which benchmarked its back-office process against its competitors. The resulting variances were 50-75% in process costs! Obviously given this kind of differentiation, efficient back-office operations can provide significant cost advantages.

Evaluating outsourcing as a strategic management tool requires a complete cost analysis. The following worksheet can assist in the completion of a true cost analysis:

In-house:
Activity costs, inclusive of labor and overhead
+ Raw Materials, inclusive of shipping, storage, handling, and overhead
+ Cost of invested capital
+ Estimated impact of outsourcing on costs and revenue
= Total cost of performing activity in-house

Versus

Outsource:
Proposal for outsourcing
+ Anticipated future pricing adjustments
+ Additional one time costs of outsourcing
+ Additional ongoing costs of outsourcing
= Total cost of outsourcing activity

The value proposition of outsourcing creates a powerful case to leverage this tool not only as a stopgap measure, but also as part of the overall management strategy.

The drive toward outsourcing is "irreversible," according to an Outsourcing Center BPO Special Report, and will have long-term ramifications of: (1) forcing companies to use process-based (activity-based) costing models and (2) eradicating 'cost centers' forever.