Recommend A Course Of Action In Outsourcing And Keep Or Replace Decisions Principles of Cost Analysis and Management © Dale R Geiger 2011 What will influence your decision? • Two cars: same model, same price, same engine, same features and accessories, same financing © Dale R Geiger 2011 Terminal Learning Objective • Task: Recommend A Course Of Action In Outsourcing And Keep Or Replace Decisions • Condition: You are a cost advisor technician with access to all regulations/course handouts, 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 © Dale R Geiger 2011 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 © Dale R Geiger 2011 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 © Dale R Geiger 2011 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? © Dale R Geiger 2011 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 © Dale R Geiger 2011 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 © Dale R Geiger 2011 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 © Dale R Geiger 2011 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 © Dale R Geiger 2011 10 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? © Dale R Geiger 2011 35 Check on Learning • Which costs are always irrelevant in keep or replace decisions? © Dale R Geiger 2011 36 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 © Dale R Geiger 2011 37 Additional Business, Reduced Price Status Quo With Additional Breakfast sales 40 @ $5 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 115 @ $2 (150) Item Fixed Costs Net Change $200 80 500 -380 © Dale R Geiger 2011 230 500 -305 Δ -075 38 Additional Business, Reduced Price Status Quo With Additional Breakfast sales 40 @ $5 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 115 @ $2 (150) Item Fixed Costs Net Change $200 80 500 -380 © Dale R Geiger 2011 230 500 -305 Δ -075 39 Additional Business, Reduced Price Status Quo With Additional Breakfast sales 40 @ $5 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 115 @ $2 (150) Item Fixed Costs Net Change $200 80 500 -380 © Dale R Geiger 2011 230 500 -305 Δ -075 40 Additional Business, Reduced Price Status Quo With Additional Breakfast sales 40 @ $5 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 115 @ $2 (150) Item Fixed Costs Net Change $200 80 500 -380 © Dale R Geiger 2011 230 500 -305 Δ -075 41 Additional Business, Reduced Price Status Quo With Additional Breakfast sales 40 @ $5 40 @ $5 + 75 @ $3 $425 $225 Variable Costs 40 @ $2 115 @ $2 (150) Item Fixed Costs Net Change $200 80 500 -380 © Dale R Geiger 2011 230 500 -305 Δ -075 42 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 â Dale R Geiger 2011 43 Additional Business, Reduced Price • What else should the dining hall management consider? © Dale R Geiger 2011 44 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? © Dale R Geiger 2011 45 Discharge or Re-train Item Benefit of trained soldier Cost of Basic Training Cost of Re-training Net Change Discharge Re-train Δ -0- X X Y -0-Y Y Z X–Y–Z -0(Z) X–Z If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable © Dale R Geiger 2011 46 Discharge or Re-train Item Discharge Cost of Basic training is a Sunk Benefit of trained -0Cost and therefore irrelevant soldier Cost of Basic Training Y Cost of Re-training -0Net Change -Y Re-train Δ X X Y Z X–Y–Z -0(Z) X–Z If X (benefit of trained soldier) is greater than Z (cost to re-train) then re-training is desirable © Dale R Geiger 2011 47 Check on Learning • Which costs are irrelevant in deciding whether to accept additional business at a reduced price? • What is the rule of thumb? © Dale R Geiger 2011 48 Practical Exercises © Dale R Geiger 2011 49 ... Cost) COA #1 COA #2 Revenue Revenue COAitem #1 is the COA If the same#2 Cost A from from for COA #1 andCost COAA#2 COA COA #2 the Δ#1will be -0Cost B fromthe Cost indicating itemBisfrom COA #1... Organizing the Data • Based on the Statement of Activities Item Related Cost B COA #1 Revenue COA #1 Cost A from COA #1 Cost B from COA #1 COA #2 Revenue COA #2 Cost A from COA #2 Cost B from COA. .. Organizing the Data • Based on the Statement of Activities Item Related Cost B COA #1 Revenue COA #1 Cost A from COA #1 Cost B from COA #1 COA #2 Revenue COA #2 Cost A from COA #2 Cost B from COA