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COST EFFICIENCY

Is Outsourcing More Expensive or Cheaper? ABC Can Tell Us

By Christopher Brown

Interviewing applicants for a new accounting position, the businessman asks a simple question, “What is one plus one?” Each puzzled candidate answers correctly, “Two,” and is summarily dismissed. Finally an interviewee comes up with the answer that lands him the job, “How much do you want it to be?”

This tired old accounting joke illustrates a point; creative accounting can make numbers meaningless.

No good business can operate that way. But the government can. And that’s a huge problem when deciding how to spend finite tax dollars on seemingly endless global stability solutions. Without exact knowledge of how much a given item or service costs the taxpayer, it is impossible to allocate funds to solve problems with maximum efficiency and effect.

This lack of accountability means needless suffering for the people we are trying to help. It can also mean senseless injuries and deaths of our military troops in the field.

Creating Motivators for Efficient Spending

For many involved in explaining government spending, the principle of “how much do you want it to be?” tends to be the rule. Combined with political agendas, such practices are outright damaging to efficiency in operations and drive up overall costs. The same individuals who embrace a view of “the government that manages most manages best” tend to find ways of portraying government inefficiency as more cost-effective for the taxpayer than any potential private sector alternative. The general approach seems to be the belief that government workers lack selfish motivation and are more altruistic than their private sector counterparts.

Such an argument—and resulting policies—ignores basic market forces as they relate to efficiency. If there is no profit motivation, then there is little motivation to keep costs down; a situation made worse by the perception of endless government resources.

In the end, advocates of this pattern of precarious financial activities will not be left with the bill. Unlike private individuals and companies, they face few or no consequences for their actions.

So the question is, “How does profit motivation drive costs down?” The most obvious answer is competition. As a market force, nothing is more likely to drive increased efficiency than the real possibility that resources, whatever they may be, might find a new home. Even the most jaded bureaucrats do not wish to see their personal fiefdoms decreased in size.

Many critics of outsourcing of government functions use any number of statistical and accounting tools to demonstrate that it costs more to go through contractors than government agencies. Sometimes it might be cheaper or more efficient for the government to perform certain activities on its own. The problem is that lack of uniform accounting methods prevents policymakers and the public from knowing what costs what.

How Outsourcing Saves Taxpayer Money

Outsourcing critics often use a method called traditional cost accounting (TCA) to arrive at their figures. Under the TCA formula, one takes the direct cost of any product or service, which is made up of the labor and resources involved in production. An arbitrary percentage of the total indirect or overhead costs is added to arrive at the supposed cost of the product or service.

This method seems straightforward, as the overhead costs of a company or agency must be accounted for in some form, and those costs must be figured into the final price of the good or service. However, its arbitrary nature can potentially distort or manipulate actual costs, versus the actual profitability or efficiency of production or distribution, of any individual product or service. Additionally, efficiently produced products or services tend to end up subsidizing inefficient products or services. Thus, the public is left with an unofficial efficiency tax which negatively impacts productivity.

When one adds the motivational forces at play, from a government’s natural tendencies toward expansion and anticompetition, suddenly there are a litany of examples of the expense of outsourcing government services or activities to the private sector. After all, if you have to pay a contractor almost twice the salary you would pay a government employee, doesn’t that equal greater costs for the taxpayer?

In relation to direct costs, the critics can be correct; however, in indirect costs—the ultimate cost to the taxpayer—entirely different factors are at work. Government employees are paid whether or not they are needed. Contractors bill only their actual hours and when the work is done, they are of no more cost to the government.

Employee benefits are a huge indirect cost. A government employee’s benefits come from the taxpayer and will paid be throughout the employee’s career, and in many cases through the employee’s retirement until death, with spousal benefits after death, plus all inflationary and other increasing costs at play.

On the other hand, the private contractor’s benefits will be part the cost of the contract though these are not open-ended commitments. The exact costs are known in advance. In fact, if the contractor is working on multiple contracts, and many are, those indirect costs are spread over multiple funding sources. Similar differences come into play for issues such as travel, equipment, training, or any number of other potential overhead expenses that critics often fail to factor in. A contractor is paid for work performed, not for nonproductive time spent during the duration of that contract.

Know Your ABCs

This is where the idea of Activity-Based Costing (ABC) balances the picture.

Under an ABC system, the indirect cost of each product or service is calculated in real terms based on the activities involved (see the special report on Activity-Based Costing). The steps to this process are as follows:

1. Identify the activities—The activities can be as expansive as the entire production and delivery process of a factory in relation to the production of a product, or as simple as figuring out the amount of energy and maintenance costs needed to run a single machine providing a service for a given period.
2. Determine the cost of each activity—Focus on the specific activities and costs relating directly to the production of a product or service while ignoring extraneous factors.
3. Determine the cost drivers—Focus on the actual costs generated by this specific activity. For example, if a product is created on a machine that requires a great deal of regular maintenance, then the cost of maintenance must be factored into the activity costs of production.
4. Collect activity data—Here begins the analysis of the activities that produce the costs in the production of distribution.
5. Calculate the cost of the product or service—Once information has been gathered and actual costs of the activities relating to the good or service are understood, then the actual cost of production can be determined by adding these indirect costs to the direct costs.

A Tool to Allow Real Cost Comparison

Of course, this process will not suddenly make an organization efficient any more than buying a filing cabinet will organize an office. However, ABC will equip an individual, or in the case of the government, the public and policymakers, with information on the actual costs associated with any given activity or product. Once this is understood, inefficiencies may be addressed, or in many cases it may be revealed that the private sector is better able to accomplish a task.

The motivation of profit versus cost has the power to drive organizations toward the most efficient use of resources and labor while holding down indirect costs. Alternatively, it may turn out that the government is better equipped to provide a service but the use of the ABC system will identify the inefficiencies that drive up costs of products or services.

Adoption of an Activity-Based Costing model will provide a more accurate picture, which, when combined with the prospect of real competition, will introduce the market forces that government agencies and programs by their very nature lack. Market forces will in turn benefit government efficiency and, more importantly, ensure that citizens receive the greatest benefit possible from their tax dollars.

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From the March/April 2008 issue of Serviam.