Outsourcing opportunities for small businesses: A quantitative analysis

Sidney J. Baxendale
Professor of Accountancy, University of Louisville, Louisville, Kentucky (baxendale@louisville.edu)

uch has been written about the advantages and disadvantages of outsourcing a firms manufacturing, service, and administrative operations in order to permit it to focus on its core competencies. There has been a tendency, however, to neglect the very basic quantitative analysis that is essential in identifying the financial parameters of deciding to outsource. Large corporations have financial personnel who are trained and widely experienced in performing the analysis necessary to make sound outsourcing decisions. But what about small business owners? They are not likely to have such a skilled and experienced staff. Of course, this decision cannot be based solely on quantitative elements. Finance is only one dimension to consider. Qualitative factors, including flexibility, trust, quality, dependability, timeliness, and reliability, are also critical. However, the complexities of an outsourcing decision are such that the small business owner must not neglect or minimize the importance of financial input. This article attempts to help small firms determine the costs that are relevant in various outsourcing decision situations, suggesting frameworks and analysis tools that are appropriate in different circumstances. To explore these various frameworks and tools, it is first necessary to define the term relevant costs.

Outsourcing has become a

way for companies to change
their cost structures overnight.
A cost that is both variable and
fixed can be transformed into truly
variable. Depending on the types of
relevant costs, a firm must decide between
outsourcing and do it yourself. But how can a small business owner determine whether a cost is relevant? The frameworks suggested here offer examples of quantitative analysis using combinations of variable direct, labor, discretionary fixed, and committed fixed direct costs. Using learning curve analysis, demonstrated indifference, Monte Carlo simulation, and economic value added, accountants can evaluate such situations and help steer the firm toward the right decision.

Relevant costs

here is a well-established quantitative approach to evaluating outsourcing opportunities that focuses on relevant costs and a comparison of the two alternatives (outsourcing versus do-it-yourself). The relevant costs are those that will differ between the alternatives. Any discussion of these costs must first start with some of the basic concepts of cost behavior, including variable versus fixed and direct versus indirect. Variable costs are those that will vary in proportion to changes in the level of activity. For example, raw materials
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S.J. Baxendale / Outsourcing opportunities for small businesses: A quantitative analysis

are a variable cost in a manufacturing situation. The more product manufactured, the higher the variable raw material costs. In the case of a service such as training, the training materials would be a variable cost because the more people trained, the more materials required. On the other hand, fixed costs are those that do not change in proportion to a change in activity level. In the manufacturing situation, the salary of the plant manager is a fixed cost; it does not vary as the quantity of goods produced varies from one month to the next. In the training situation, the salary of the training manager does not vary depending on the number of people trained. Of course, this assumes that the trainer is an employee of the company, not a contract trainer. The distinction between direct and indirect costs is similar to that between variable and fixed costs, but with a subtle difference. Direct costs can be traced directly to a unique product or service. The raw materials used in making a product and the training materials used in training sessions are classified as direct costs because they can be traced uniquely to a product or service that uses them. Thus, we can conclude that variable costs are always direct costs. However, the reverse is not true; direct costs are not always variable. This will be clarified after we consider the nature of indirect costs. Indirect costs are those that are shared by products or services. If a machine in a factory is used to make two or more products, then the depreciation (a fixed cost) on that machine is an indirect cost to each of the products. If that same machine were dedicated to making one unique product, then the depreciation would be regarded as a direct cost to that product. Thus, fixed costs, such as depreciation, can be classified as either indirect or direct, depending on the situation. Table 1 summarizes the relationship between all these types of costs. As mentioned earlier, the outsourcing decision focuses on the relevant cost differences between the two alternatives. The conclusion drawn from this brief cost tutorial is that the relevant costs between the two alternatives are going to be variable and direct fixed costs because those are the only ones that will vary between the alternatives of outsourcing and in-house work.

Direct and variable costs

Lets use a numerical example to demonstrate the decision analysis involving costs that are clearly both direct and variable. Assume that Ann, a small business owner, is trying to decide whether to assemble a rather complex subassembly or contract to have it outsourced to a manufacturer that specializes in subassemblies. Her employees have been assembling the item for a short period of time and it is clear that the complexity of the process has upped its costs to more than she had originally estimated. The contract manufacturer approaches Ann with a proposal for her to outsource the product at a cost of $230 per unit delivered to her place of business. Ann knows that the raw materials are $100 per unit of product and the labor required to assemble the product is $200 per unit. She realizes that the raw material costs and assembly labor are variable direct costs that will be eliminated if she chooses to outsource the manufacture of the product. And she would have to lay off or terminate those employees involved in assembling the product. In this instance, there are no fixed costs, such as assembly supervision salaries or equipment depreciation, that are direct. Only the assembly supervisor will have to be retained to supervise other products, and the subassembly requires no dedicated equipment. Thus, the raw material, labor, and outsourcing costs are the only ones that are relevant to the outsourcing decision. If Ann continues to have her employees put together the subassembly, the cost will be $300 per unit; however, if it is assembled by the contract manufacturer, the cost will be only $230 per unit. Therefore, it is clear that Ann should choose to outsource.

Considerations of learning with relevant labor costs

Table 1 Relationships among cost categories

Variable costs Fixed costs Direct costs Indirect costs Always direct May be direct or indirect May be variable or fixed Always fixed

ased on the direct variable cost information presented in our first example, it seemed clear that it would be advantageous for Anns company to outsource the subassembly because its intricate nature resulted in labor costs that were higher than expected prior to the start of assembly. However, that analysis failed to consider that Anns assembly workers will learn of more efficient ways to assemble the intricate unit as they build more of them. Learning curve analysis, as defined by Horngren, Datar, and Foster (2002), provides an analytical framework within which to estimate the direct labor portion of the direct variable costs more reliably. With its origins in industrial psychology, learning curve analysis is based on the assumption that the workers will find more efficient ways of performing a task as it is repeated. An 80 percent

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S.J. Baxendale / Outsourcing opportunities for small businesses: A quantitative analysis

learning curve assumes that every doubling of the cumulative quantity manufactured will result in a cumulative per-unit labor cost that is 80 percent of the previous cost. In the earlier example, the first production batch of the subassembly resulted in a labor cost of $200 per unit. Assuming that each production batch size was 1,000 units of the subassembly, the 80 percent learning curve analysis is presented in Table 2.

Table 2 80% learning curve example

Cumulative quantity 1,000 units 2,000 units 3,000 units 4,000 units 5,000 units 6,000 units 7,000 units 8,000 units Cost per cumulative unit $200.00 $160.00 $128.00 Cumulative cost $200,000 $320,000 $512,000

When the cumulative quantity doubles after completing the second batch, the 80 percent learning curve suggests that the cost per unit for the cumulative number of units will be 80 percent of its former cost per unit. Thus, it drops from $200 to $160. When $160 per unit is multiplied by the 2,000 cumulative units, the cumulative cost is $320,000. Thus, efficiencies learned and implemented while making the second 1,000 units are expected to result in a labor cost of those 1,000 units being only $120 per unit (($320,000 $200,000) / 1,000 units). When the cumulative number of units doubles from 2,000 to 4,000 (after the completion of the third and fourth batches), the cost again declines to 80 percent of the former cost, or $128, and the total cost for the 4,000 units becomes $512,000. The total direct variable cost is $912,000 ($512,000 for labor and $400,000 for raw materials). If Ann had outsourced the production of the subassembly at $230 per unit, the total cost for 4,000 units would have been $920,000. To take this learning curve analysis one step further, consider what is expected to happen to labor costs when the cumulative production doubles again. After eight batches, the cumulative production will have doubled again to 8,000 units, with a cost per cumulative unit of $102.40 ($128 x 80%) and a cumulative labor cost of $819,200 (calculated by multiplying the 8,000 cumulative units times $102.40). Thus, the cost per unit for the production in batches 5, 6, 7, and 8 averages $76.80 (($819,200 $512,000) / 4,000 units). This suggests that after producing the eighth batch of subassemblies, the relevant variable direct cost per unit will be $176.80 ($100 of raw materials and $76.80 for labor), whereas the outsourcing cost would still be $230 per unit. It is clear that Ann will have a definite cost advantage in producing the subassemblies with her own employees. This learning curve analysis could be expressed in a simple computer model using Microsoft Excel or some other electronic worksheet, with which it is possible to perform various what-if inquiries. For example, although an 80 percent learning curve is most often used for production

Batch # Quantity 1 1,000 units 2 1,000 units 3 1,000 units 4 1,000 units 5 1,000 units 6 1,000 units 7 1,000 units 8 1,000 units

$102.40

$819,200

situations, the situation may be one in which the percentage is expected to be less (faster learning) or more (slower learning). The computer model would permit a quick evaluation of the impact of a learning curve percentage change from 80 percent to some other amount, or an evaluation of a situation in which the percentage might be low in the early batches and high in the later ones. It would also permit an evaluation of learning curve percentage that would justify doing the operation in-house. Excel has a goal seek function that, when used properly with the computer model, will reveal the learning curve percentage that can yield a cost per unit equal to the cost per unit when outsourced. The user can easily evaluate how many batches must be produced before in-house production is economically justified. Because the learning curve effect is diminished as the number of batches increases, the user may find that it is not reasonable to expect the in-house cost per unit ever to become less than the outsourced cost. Labor turnover is an important consideration in using the learning curve analysis. Companies with a stable labor force are more likely to find it useful in evaluating outsourcing decisions. On the other hand, for a company that has high turnover, any learning curve advantages might be diminished by the need to constantly train the new employees. Although a manufacturing example has been used here to help explain learning curve analysis, it is important to point out that the analysis is applicable in many nonmanufacturing operations that involve repetitive actions. There are several repetitive service processes such as claims, invoices, payroll, and customer orders that may be candidates for outsourcing. Learning curve analysis is an appropriate tool in assisting in those outsourcing decisions as well.

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Both direct variable and discretionary direct fixed costs: Indifference analysis

hen direct fixed costs are relevant to the outsourcing decision, the framework for the analysis changes. Using a different example, lets assume that two machines are used in machining materials to produce a low-volume product that is being considered for outsourcing. Both machines are rented. Machine A is a drill that is used solely in drilling the product. Its rental rate is $100,000 per year. Machine B is a cutter used to cut the material for the product, but it is also used for cutting high-volume products that are not under consideration to be outsourced. The rent for Machine A is considered a direct fixed cost and is relevant in the outsourcing decision. By its nature, it is fixed because it will not change from month to month as a result of changes in the number of product units manufactured. It is direct because it is related only to the low-volume product being considered for outsourcing. If the product is outsourced, Machine A will be returned to the rental company and the rent will be avoided. The rent associated with Machine B is not relevant to the outsourcing decision because Machine B will have to remain to produce other products even if the low-volume product is outsourced. The rent is an indirect fixed cost in relation to that product. We regard the direct fixed costs associated with Machine A as discretionary because the rental contract is such that management may choose to avoid paying the rent by returning the machine at its discretion. If the company owned the machine, management would not have nearly as much discretion in avoiding the fixed costs (depreciation, cost of capital, and so on). The machine would be considered a committed fixed direct cost. Later, we will suggest an analytical framework that is appropriate for evaluating outsourcing decisions that involve these latter costs. The direct variable costs associated with the manufacture of the low-volume product are identified as $200 of raw materials and $400 of labor per unit. The company has been producing the product long enough that any learning curve effects have been realized and the labor cost has stabilized at $400. The rent of Machine A is the only fixed cost that is uniquely associated with the product. Thus, the $100,000 per year is a direct fixed cost and is relevant to the outsourcing decision. The outsourcer has offered to manufacture the product under a contract at $700 per unit delivered to the companys site. After relevant costs have been identified, the outsourcing decision must be placed in the proper quanti-

tative framework using an indifference analysis, which seeks to determine the indifference point: the number of units of annual production at which the business owner call him Davewould be indifferent between outsourcing and continued in-house manufacturing. This is an important framework when there are fixed costs among the relevant costs. If X is the indifference point, the calculation is as follows: $700X = $100,000 per year + $200X + $400X $100X = $100,000 X = 1,000 units of product per year Therefore, if Dave expects to produce more than 1,000 units of the low-volume product per year, he should continue to do the manufacturing. However, if he expects to produce fewer than 1,000 units, he should give serious consideration to outsourcing. If the production were expected to be precisely 1,000 units per year, he would be indifferent between manufacturing and outsourcing because both alternatives would result in the same annual cost. Of course, this analysis presumes that Dave could quickly terminate the lease cost of $100,000 per year by returning the machine if he chooses outsourcing. In this discussion of relevant costs, we have assumed that Daves firm was already manufacturing the product and had been approached by a contract manufacturer. The same type of analysis would have been performed if the product were currently being manufactured by a contractor and Dave were considering bringing its manufacture in-house. However, in this situation Dave would not have firsthand knowledge of the costs. He would have to deal with more uncertainty in the estimates for the variable and direct fixed costs associated with do-it-yourself manufacturing.

Dealing with uncertainty: Monte Carlo simulation

s suggested by the above examples, the outsourcing decision seems much easier after the relevant costs have been identified and the proper framework for analysis has been employed, but that is an oversimplification. So far we have assumed that we can accurately estimate the variable costs per unit, the fixed costs per period of time, and the number of units expected to be produced in the future. However, accurate estimation of those amounts is not always possible. Monte Carlo simulation provides an opportunity to systematically introduce uncertainty into an outsourcing decision. Previously, this was available only through expensive computer packages or separately purchased add-ins to be used with popular electronic spreadsheets.
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S.J. Baxendale / Outsourcing opportunities for small businesses: A quantitative analysis

But Microsofts Excel now has data analysis features that permit Monte Carlo simulation without having to buy an add-in. The following example explains how that type of analysis can be accomplished using Excel. In the previous indifference analysis, we assumed that the raw material costs were $200 per unit, labor was $400, and the direct fixed costs of producing the low-volume product were $100,000 per year (rent that could be avoided). The cost of outsourcing was going to be $700 per unit. The indifference point was 1,000 units per year. Two of the estimates associated with this outsourcing situation are certain. A contract with the outsourcer will specify the cost of $700 per unit with certainty. And the $100,000 per year machine rental is also subject to a contract. The material and labor costs are likely to be uncertain because the amounts of raw materials and labor used to make the product may vary from time to time due to unexpected events and changing efficiencies. Moreover, those per-unit costs may change during a year if there are no contracts specifying them. Another obviously uncertain estimate is the number of units that will be produced during the year. Monte Carlo analysis permits an explicit assessment of the uncertainties associated with these estimates. Lets assume that the number of units most likely to be produced will be 900 per year, and there is no possibility that the production will be less than 600 or more than 1,200. If we assume a normal distribution, we can conclude that the mean of the estimate is 900 units and the standard deviation is 100. This is because a normal distribution is based on the assumption that 100 percent of all possibilities lie within three standard deviations on either side of the mean. Using the parameters estimated for annual unit

sales, three standard deviations on the negative side of the mean (the most likely estimate) of 900 gives us the lowest possible estimate of 600 units per year. On the positive side of the mean, we add three standard deviations to arrive at the highest possible estimate of 1,200 units per year. This normal distribution is represented by a bellshaped curve, which suggests that the likelihood of any particular number diminishes depending on how far the number is from the mean. Thus, unit sales of 600 per year are less likely than 800, and unit sales of 950 per year are more likely than 800. The likelihood of 600 is nearly identical to that of 1,200, and both are very low. The same estimation approach using a normal distribution can express the uncertainty of the per-unit costs of both raw materials and labor. Assume that the material cost is represented by a normal distribution that has a mean of $200 (the most likely as per the earlier estimate) and a standard deviation of $10. Thus, the expectation is that the cost will be between $170 and $230 per unit (three standard deviations on either side of the mean). Again, because of the assumed normal distribution, $210 is more likely than $175. Using the same concept of a normal distribution, lets assume that the mean of the labor cost is $400 per unit (the most likely as per the earlier estimate) and the standard deviation is $5. Using Excels Analysis Tool Pack, three sets of 1,000 random numbers are generated using these mean and standard deviation parameters (see Table 3). The 1,000 unit per year production numbers are placed in column A of the worksheet, the 1,000 per-unit raw material cost numbers are placed in column B, and the 1,000 per-unit labor cost numbers are in column C. The random numbers for

Table 3 Monte Carlo Analysis Excel spreadsheet example (partial)

Results from three sets of random numbers: 1,000 random numbers each (Only the first 10 of the 1,000 rows shown) Column A Column B Column C Column D Results from "rank and percentage" using Excel's Analysis Tool Pack (Only the first 10 of the 1,000 rows shown) Column E Total variable cost: Highest to lowest of the 1,000 samples $735,402 $727,830 $715,650 $715,185 $714,332 $709,084 $700,199 $689,908 $687,351 $686,428 Column F Column G % of 1,000 samples < or = Column E amount 100.0% 99.8% 99.7% 99.6% 99.5% 99.4% 99.3% 99.2% 99.1% 99.0%

Unit production per year, mean of 900, std. dev. of 100 923 808 933 1,127 784 912 1,028 791 900 986

Raw material costs per unit, mean of $200, std. dev. of $10 $178.00 $199.23 $222.40 $204.25 $199.61 $195.82 $206.33 $199.08 $202.92 $196.68

Labor costs per unit, mean of $400, std. dev. of $5 $410.00 $395.45 $400.37 $401.33 $395.10 $395.91 $395.74 $400.35 $394.59 $399.56

Total variable costs per year if not outsourced A * (B+C) $542,724 $480,370 $580,932 $682,195 $465,955 $539,549 $618,958 $474,063 $537,527 $588,035

Rank: 1 to 1,000, high to low 1 2 3 4 5 6 7 8 9 10

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each of the three uncertain variables are selected using the mean and standard deviation specified for each variable (900 and 100 for production, $200 and $10 for raw materials, and $400 and $5 for labor). Column D is used to calculate total variable costs for the year by multiplying, for each of the 1,000 rows of data, the units produced per year in column A times the sum of raw material and labor in columns B and C. Thus, if the

consider that the per-year costs associated with producing the low-volume part also include $100,000 machine rent, then we can conclude there is a 50 percent chance that the total cost per year will be between $681,047 and $595,904. Now we must use the same normal distribution for unit sales to determine what the total per-year costs are likely to be if the low-volume product manufacturing is outsourced. In this case, the random numbers in column A representing the number of units per year would be multiplied times the $700 outsourcing cost per unit, and the mathematical product would be placed in another column. The 1,000 total annual outsourcing costs in that column would then be subjected to the rank and percentage routine, revealing a 75 percent probability that the total annual cost would be $678,709 or less and a 25 percent probability that it would be $577,010 or less. Thus, there is a 50 percent probability of a total annual outsourcing cost between $678,709 and $577,010. The summary of the comparative Monte Carlo analysis is as follows:

Monte Carlo simulation provides an opportunity to systematically introduce uncertainty into an outsourcing decision.
numbers in the first row of columns A, B, and C are 923, $178, and $410, respectively, the total variable cost associated with the random numbers in that first row would be $542,724 (923 x ($178 + $410)). That random estimate for the year is placed in the same row in column D; and column D will contain 1,000 estimates of total variable costs for the year when the logic for its first row is copied to the remaining 999 rows. Because the number in column D is the sum and product of the random numbers in columns A, B, and C that come from normal distributions, it likewise has a normal distribution. After the 1,000 total variable costs per year are calculated in column D, they are arrayed in column E from the largest to the smallest, and rank-ordered in column F. Next to the rank-ordering, column G shows the percentage of the thousand numbers that are equal to or less than the ranked variable cost per year on any row. Thus, the ranked variable cost per year that appears in the first row is such that 100 percent of all the 1,000 variable costs per year are equal to or less than that particular high amount. The rank and percentage routine in Excels Analysis Tool Pack does the ranking and calculates the percentages automatically. We can scan the output from the rank and percentage routine and draw conclusions about the likelihood of various ranges of per-year variable costs. For example, at the 75 percent row, the variable cost per year number in column E is $581,047. Scanning further down, we find a cost of $495,904 in the 25 percent row. Because there are 50 points between 25 and 75 percent, we can conclude that there is a 50 percent probability that the variable costs per year will be between those two dollar amounts. When we

TOTAL ANNUAL COST Do-it-yourself Outsource 50% probability range with the mean in the center, i.e., between 75 and 25% probability $681,047 to $595,904 $678,709 to $577,010

Because the outsourcing 50 percent probability range has end points that are slightly lower than the similar probability range for the do-it-yourself alternative, the quantitative analysis marginally supports the use of outsourcing. Using the rank and percentage columns for each of the two alternatives, different probability ranges could be determined and compared. The 50 percent range was chosen in this example because it is the easiest to explain. Repeated Monte Carlo simulations with varying means and standard deviations for the estimated costs of production will provide additional information about the sensitivity of the results to changes in the parameters associated with the input variables (direct material cost per unit, labor cost per unit, and units produced in our example). This sensitivity analysis is sometimes useful in determining which parameters (mean or standard deviation) of which input variables have the greatest impact on the analysis results. Those that have the greatest impact would be subjected to greater attention in specifying the means and standard deviations. It is important to note that any attempt to duplicate this example will not result in the same identical numbers cited. That is because the random number generator will generate a unique set of numbers each time it is used. However, an attempt to duplicate the analysis should result in nearly identical results.

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Both direct variable and committed direct fixed costs: EVA

level equal to that associated with the business. The cost of equity capital will always be greater than the pre-tax cost of debt capital because the equity shareholder bears more risk than the lender. If we assume that the net operating profit (on an after-tax basis) is $200,000, then the EVA calculation is Net operating profit (after-tax) $200,000 Less capital charge: Capital employed $1,000,000 Weighted avg. costs of capital x 13.948% Less capital charge 139,480 EVA $60,520 EVA can also be used as a framework for decision-making when the decision involves committed fixed costs. Lets turn now to a small business owner, Samir, who is considering the alternatives of acquiring a small fleet of delivery trucks or continuing to use contract delivery services. The savings associated with owning the fleet should be large enough to cover the cost of capital involved. The use of EVA to evaluate the choice results in the cost of capital being explicitly considered. When comparing the two alternatives, we start with the relevant direct variable and fixed costs such as depreciation on the acquired asset. Based on the expected amount of delivery services he expects to need during a typical year in the future, Samir first determines whether the operating profit is expected to increase or decrease if he acquires the delivery fleet. If it is expected to decrease when just the direct variable and direct fixed costs are considered, then he should continue outsourcing the delivery services. However, if it is expected to increase when just those costs are considered, then he must use EVA analysis to determine whether the increase will be sufficient to cover the costs of capital associated with buying the trucks. Lets assume that the consideration of direct variable and direct fixed (depreciation) costs and expected deliveries reveals that acquiring the fleet would raise after-tax operating profits by $50,000 per year ($78,125 pre-tax operating profit taxed at a marginal tax rate of 36 percent). Assume also that the acquisition would cost $200,000 and the after-tax cost of capital is the 13.948 percent calculated earlier. The EVA calculation is: Increase in operating profit for the year (after-tax) $50,000 Less capital charge: Cost of delivery fleet $200,000 Weighted avg. cost of capital x 13.948% Less capital charge 27,896 EVA for acquisition of fleet $22,104 The fact that the EVA amount is positive suggests that acquiring the delivery fleet would be the better choice because the after-tax operating cost savings would more
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ome outsourcing decisions involve fixed costs that are committed. A small business owner wanting to acquire a fleet of delivery vehicles in lieu of continuing to use contract delivery would have to consider a committed fixed costthat associated with owning the fleet. In such a situation, the cost of the capital tied up in the fleet is relevant to the outsourcing decision. That capital and the depreciation of the asset cost are both relevant committed fixed costs. Of course, certain direct variable costs, such as fuel and maintenance, are also relevant.

An appropriate analysis framework to use when capital costs are relevant is economic value added (EVA, a registered trademark of Stern and Stewart), which is net operating profit (on an after-tax basis) less a capital charge. The net operating profit is the earnings before interest deduction. Effectively, it represents the profit from the business operations without deducing any interest expense associated with financing the business using debt financing. Many small firms have no debt financing. Thus, their net operating profit (on an after-tax basis) is the same as their aftertax income. The capital charge, which is subtracted from the net operating profit, is an imputed cost (not recorded as an actual accounting transaction) associated with the capital that is used in the business. It is determined by multiplying the estimated cost of the capital times that used in the business. The latter is determined by referring to the balance sheet. It is the sum of the interest-bearing debt and stockholders equity. The cost of capital used in determining the capital charge is the after-tax weighted average cost of the capital used. Its calculation recognizes that interest expense is tax deductible, whereas the cost of equity capital is not. For example, if a small business has $100,000 of 7 percent debt and $900,000 of equity financing, the after-tax weighted average cost of capital is calculated as follows, assuming that the marginal tax rate is 36 percent and the cost of equity capital is 15 percent: Debt $ 100,000 x (.07 x (1.36)) = $ 4,480 = 135,000 Equity 900,000 x .15 Total $1,000,000 $139,480 After-tax weighted average cost of capital = $139,480 / $1,000,000 = 13.948% The cost of equity capital is essentially the return that shareholders consider appropriate given the level of risk they are undertaking. Determined subjectively, it represents the shareholders opportunity costthe rate at which they could earn on an investment that has a risk
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than cover the committed fixed capital costs (by $22,104 per year). If the EVA amount had been negative, Samir would have concluded that the after-tax operating cost savings, as indicated by the direct variable and fixed cost analysis, would not be enough to justify incurring the annual committed fixed capital costs associated with acquiring the fleet.

here are many qualitative factors a small business owner must consider when attempting to decide whether to outsource or do it yourself. We have not dealt with those important considerations. Instead, we have focused solely on the quantitative analysis of such a decision. To summarize, quantitative analysis requires thoughtful consideration of the costs that will be relevant in choosing between two alternatives. Once those relevant costs have been identified, the framework of the analysis must be chosen. When only variable direct costs based on longterm experience are relevant, the analytical framework is rather simple. However, if the variable direct costs include labor estimates based only on limited in-house experience, then learning curve analysis should be factored into the framework. If the relevant costs include discretionary direct fixed costs, the appropriate analytical framework is the indifference analysis. Because the do-it-yourself alternative includes the discretionary direct fixed costs and outsourcing includes only variable direct costs, indifference analysis is essential in determining how many units

must be produced to render the business owner indifferent between the two alternatives. Once that point has been determined, it still may not be clear which alternative is the most favorable from a quantitative analysis viewpoint because the number of units expected to be produced may be uncertain. That uncertainty is capable of being assessed and quantified using Monte Carlo analysis (readily available for use with Microsoft Excel). In instances in which the relevant costs include committed direct fixed costs, EVA is the most appropriate analysis framework because it properly considers the cost of capital among the relevant costs. Although qualitative analysis is the primary consideration in outsourcing decisions, crunching the numbers provides the essential financial parameters that complete the picture. But the analysis is complex enough that small business owners should have some guidance in conducting it properly.

References and selected bibliography

Baxendale, Sidney J., and Leigh Bowen. 2001. Economic value added for new ventures and small businesses. Journal of Small Business Strategy 12/2 (Fall-Winter): 41-51. Ehrbar, Al, G. Bennett Stewart, and Joel M. Stern. 1998. EVA: The real key to creating wealth. New York: John Wiley & Sons. Horngren, Charles T., Srikant M. Datar, and George Foster. 2002. Cost accounting: A managerial emphasis, 11th ed. Upper Saddle River, NJ: Prentice Hall.

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