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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...