Make or buy? Using cost analysis to decide whether to outsource public services.

• Author: Michel, R. Gregory
• Position: Government Finance Officers Association article

Editor's note: This article is adapted from a new GFOA publication, Cost Analysis and Activity-Based Costing for Government.

In this period of tight budgets, many governments are under increasing pressure to do more with less. One potential way to reduce costs is to outsource services to private firms, non-profit organizations, or other governments that can provide the services more efficiently. In some cases, outsourcing can result in significant cost savings over the long run. In other cases, however, outsourcing may actually end up increasing a government's total costs. How can a government know whether outsourcing a given service will result in a cost savings or a cost increase? This article answers this question by demonstrating how to perform a cost analysis.

The decision as to whether to perform a service "in house" or outsource it to an external provider is commonly referred to as the "make-versus-buy" decision. This article walks through the steps involved in a make-versus-buy cost analysis. But first, two key points warrant emphasis: (1) a make-versus-buy cost analysis should use a differential cost perspective and (2) the analysis should cover a multi-year period and discount future cash flows to their present value.

USE A DIFFERENTIAL COST PERSPECTIVE

Differential cost is the key cost concept for evaluating the outsourcing of a service. The differential cost shows how a decision to outsource will change a government's costs. It is crucial to look at the differential costs instead of merely comparing the total costs of the status quo to the total costs of using a private contractor. The pitfall of comparing total costs is that they may include fixed costs that cannot be avoided by outsourcing a service. This could give the appearance that a government will incur fewer costs by using a private contractor when it actually will incur more. (1)

For example, let's say that a private waste hauler offers to provide waste collection services to the City of Unionsville for $550,000 per year. As it stands, the total cost of providing waste collection services is $750,000 per year. Thus, it appears that the city could save $200,000 per year by hiring the private hauler. However, a closer look at the city's fixed costs reveals that it is committed to spending much of the $750,000 whether or not it switches to a private hauler. More than half of this amount is personnel costs, which the city cannot avoid because of a "no-layoff" policy and the fact that the truck drivers perform other responsibilities. Likewise, the city is committed to $50,000 per year in debt service payments for the facilities used to store and maintain its garbage trucks.

Sunk costs. A potential mistake in a make-versus-buy cost analysis is the inclusion of sunk costs. A sunk cost is a cost that has already occurred and will remain the same regardless of what decision is made. As such, sunk costs should be ignored in a cost analysis.

To see how including sunk costs can lead to bad decisions, suppose a county government is considering outsourcing its warehouse function to private suppliers that can maintain inventories of all the county's supplies and ship them overnight. One year earlier, the county had spent $500,000 for a consultant to develop a state-of-the-art inventory process. Opponents of the outsourcing plan argue that the county should not outsource the warehouse function because it just poured $500,000 into perfecting the existing system. However, this $500,000 should not influence the decision because it cannot be recovered regardless of the course of action the county takes; only the differential cost of the two alternatives should influence the decision. If the differential cost of outsourcing the warehouse function is $340,000 less per year than retaining this function in-house, including the sunk cost of the consulting services would lead the county to spend $340,000 per year more than it has to.

Opportunity costs. Another important cost concept in make-versus-buy decisions is opportunity cost. Opportunity cost is the lost opportunity of using an asset or resource in a way other than the chosen alternative. For example, if a suburban government sells a public swimming pool to a private company to own and operate, the opportunity cost would include the admittance fee revenue that would have been collected if the pool remained a public asset. Likewise, the opportunity cost of not selling the pool would be the revenue from the sale of the pool.

COVER A MULTI-YEAR PERIOD AND DISCOUNT FUTURE CASH FLOWS

A cost comparison should cover a multi-year period. This is important for two reasons. First, a multi-year analysis is more likely to reveal whether outsourcing will generate long-term savings. A government should experience much of the cost savings related to outsourcing in later years, as leases and contracts expire and...