Fleet Limited: A Managerial Decision Making in respect of In-house IT versus Outsourcing - Essay Example

Fleet Limited: A Managerial Decision Making in respect of In-house IT versus Outsourcing Executive Summary Managers are often confronted with situations to choose between performing an operation either in-house or getting it outsourced. In the process of taking a decision on whether to outsource or not, the important aspect to be considered apart from the qualitative aspects is the 'Relevant Costs'. Relevant costs are those appropriate to a specific management decision. Relevant costs are the future costs that will differ among alternatives. One might use the past costs to help predict those future costs but the past costs are otherwise irrelevant to the decision. Application of relevant costs in outsourcing decisions must be done with a careful understanding of all the effects of such decisions on the future profitability of the company. This is so because outsourcing decisions usually represent a permanent change in strategy and definitely will have long term implications. Careful analysis is required to ensure that the outsourcing strategy takes into account the organizations financial and business objectives and also must confirm that the vendor market place can sustain or exceed the current service levels. It is very important that such significant changes involving outsourcing decisions are implemented in stages after careful planning and execution in each stage. It is also important that the managerial decisions take into account the timings of the envisaged changes. This report on the managerial decision to outsource the IT of Fleet Limited analyses the costing aspects of the decision in detail. 1.0 Using Relevant costs in Outsourcing Decisions: As commonly understood cost is a monetary measure of the resources sacrificed or foregone to achieve a specific objective such as acquiring a good or service. In a business situation costs are important for arriving at the selling prices, planning the future production targets, making sales forecasts, making managerial decisions in different business scenario and also to exercise an effective managerial control on the operations of the firm. Depending on how the costs change or react to given business activity or volume, the costs can be classified as Variable Costs and Fixed Costs. A further analysis of these costs would result in Semi-Fixed Costs and Semi-Variable Costs. 'Variable Costs' are those costs identified to vary in direct proportion to the volume of activity. A variable cost changes in total in proportion to changes in the related level of total activity or volume. (Horngren 2004) The variable costs may include cost of goods sold or production expenses such as labor and power cost. Examples of variable costs are the cost of a component like a steering wheel bought from an external source in a car assembly or the sales commission payable as a percentage of total sales achieved. In the case of Fleet Limited the 60 percent of the overhead costs which varies with the number of staff is a variable cost. 'Fixed Costs' are those costs which remain unchanged in total for a given time period despite wide changes in the related level of total activity or volume. For example a company may incur $ 20 million in a given year for the leasing and insurance of one of its plant. Both these costs are fixed costs in so far as these costs do not change in total over a designated range of the volume of production of the firm concerned. The Rent of 10,000 per year being paid by Fleet Limited for housing the IT department is a fixed expense. A graphical representation of the fixed, variable and total costs in respect of a homecare institution is appended below: Source: Economics Interactive Tutorial Another classification of costs which is normally being used for managerial decisions in make-or-buy or outsourcing is the relevant costs and irrelevant costs. 'Relevant costs' are the amounts by which costs increase and benefits decrease as a direct result of a specific management decision. Relevant costs are the future costs that differ from the alternatives being considered. Incremental or differential costs are relevant because they are the ones that differ from the alternatives. Since all costs are not relevant, managers should identify those costs which are relevant for decision making. In the case of Fleet Limited the contract price payable of 250,000 per year is a relevant cost while considering the outsourcing decision. 'Irrelevant costs' on the other hand are those which are not related to a situation requiring management's decision. Historical costs may be a useful basis for making informed predictions of the expected future costs but they by themselves are past costs that are irrelevant for decision making. Past costs that are unavoidable because they cannot be changed no matter what action is taken are called 'sunk costs'. The 100 million spent by Fleet Limited on replacing computer systems is an irrelevant cost in the outsourcing decision. There are some potential problems in adopting relevant cost analysis. These should be carefully avoided while doing the analysis. They are: The general assumption that al variable costs are relevant and all fixed costs are irrelevant should be analysed by taking into account the relevance of each fixed and overhead costs affecting the managerial decision Unit cost data may mislead the decision maker when irrelevant costs are included in the analysis. Similarly the analysis may get vitiated when the same unit costs are used at different output levels. 2.0 Quantitative Effect of the Alternative decisions of in-housing IT and Outsourcing: The financial effects of the alternative decisions of either having the IT department in-house or outsourcing can be represented in the following way for an easy understanding of the financial implications of both the alternatives. A. IT Department as an In-house operation: Details of Costs Year 1 Year 2 Year 3 Fixed Costs: Salary of Staff 300,000 300,000 300,000 Rent 10,000 10,000 10,000 Central Overheads 40% 0f 27,000 10,800 10,800 10,800 Total Fixed Costs 320,800 320,800 320,800 Variable Costs: Consumables 5,000 6,000 7,000 Overheads 60% of 27,000 16,200 16,200 16,200 Total Variable Costs 21,200 22,200 23,200 Total Costs 342,000 343,000 344,000 B. Outsourcing of IT Department: Details of Costs Year 1 Year 2 Year 3 Fixed Costs: Contract Fee for Results Limited 250,000 250,000 250,000 Rent 6,000 2,000 0 Salary 30,000 30,000 30,000 Central Overhead 10,800 10,800 10,800 Total Fixed Costs 346,800 342,800 340,800 Relevant Costs: Salary for contract manager 50,000 50,000 50,000 Extra pension payment to Charles Smith 20,000 0 0 Overhead 60% 0f 27,000 for 2 staff 3,240 3,240 3,240 Total Relevant Cost 73,240 53,240 53,240 Total Costs 420,040 396,040 394,040 Less: Resale Value of IT equipment 30,000 0 0 Net Total Cost 370,040 396,040 394,040 2.1 Details of Cost Calculations: In-house IT Department: 1. Salary: @ 30,000 on average per person for 10 Staff amounts to 300,000 per year. No increments or salary rises have been assumed for years 2 and 3. 2. Overheads: Total Central Overheads is divided into 40 percent fixed and 60% variable. For Outsourcing: 1. Rent: From the total rent payable of 10,000 for the IT department building the subleasing charges in the respective years is subtracted and the balance shown as rent: For Year 1 10,000 less 4,000 = 6,000 For Year 2 10,000 less 8,000 = 2,000 For Year 3 10,000 less 10,000 = 0 2. Overheads: Total Central Overheads is divided into 40 percent fixed. Out of total 60 percent variable, the expenses are assumed for 10 staff and proportionately taken for one old staff and another new contract manager; totally for 2 staff 60 % of 27,000 = 16,200 divided by 10 = 1,620 multiplied by 2 = 3,240 3.0 Recommendation: Based on the cost calculations shown in the above tables, the continuance of the IT department within the company is recommended. The costing calculations do not appear to favor the outsourcing of the IT function as at present. This decision is supported by the following arguments: The total fixed costs for all the three years are comparatively higher in the case of outsourcing as compared to the continuance of the in-house operations. This will definitely affect the profitability of the company. In the costing calculations the depreciation on the total investment of the IT equipment to the tune of 100 million is not considered. If the allowable deprecation is also taken into account the proposal to run the department will be highly advisable in view of the distinct tax advantage resulting from the depreciation. The fixed part of the central overhead will continue to be charged to the department irrespective of the fact that the function is outsourced. This is incurred in addition to the cost of outsourcing. While doing the function as an in-house operation there is only a marginal increase in the variable expenses over the three year period in the form of additional consumables. This is a distinct cost advantage. Moreover the resale value of the IT equipment installed only in the last year is very low. A comparison of total fixed and variable costs under in-house operations and the total fixed and relevant costs in outsourcing reveal that the cost of outsourcing is considerably higher and hence the continuance of IT department as an in-house operation is recommended. Apart from the quantitative aspects the qualitative factors affecting the decision need to be considered. Basing on the qualitative considerations discussed elsewhere in this report also, the in-housing of the IT department is recommended. 4.0 Qualitative Factors: In addition to the financial effects the qualitative aspects should also be considered while making a decision on the outsourcing or any other make-or-buy decisions. This is of utmost importance as the capacity and reliability of the vendor plays a major role in these kinds of decision making. 4.1 Factors to consider in In-house operation: The continuance of the operation as an in-house one gives more control over the quality and reliability of the data and information being processed by the department. The timeliness of the data is of paramount importance for important management decision making process. By continuing the operation in-house the timeliness of the preparation and presentation of various information to the management can be ensured. Maintenance of the secrecy of the business if at all required can be ensured while performing the IT function as an in-house operation. In spite of the cost advantage the possibility of the organization becoming leaner and smaller may be considered. This may help in improving the core competencies of the organization. 4.2 Factors to be considered while outsourcing: On-time delivery, quality of the work, innovative ideas in processing and reliability of information may be ensured while outsourcing the IT department's function. By employing more qualified staff there is a possibility that the vendor increases the quality of his performance. This may also be possible by installing newer and speedier technology and software, which the company may not be able to do on its own because of the technological excellence involved. However when the dependence of the company increases on the vendor it ma be possible that the vendor may try to take advantage of the situation by escalating the contract price. In spite of all the advantages there is always the risk of delay in delivering the required information processed which may adversely affect the functioning of the company by not taking timely decisions. This is especially true when the sales and pricing issues are involved. Many a times the staff with the vendor may not have the necessary technical expertise required to understand the business of the company to produce intelligent business reports to help the company get a grip of the market in which it is dealing. Due to lack of technical knowledge relating to the business of the company the vendor may not be in a position to create analytical reports as may be required by the company quickly. This may involve considerable time to process and reprocess the data and information. But because of the familiarity the In-house IT department may function at a faster way to produce the required reports. Conclusion: This report has made an analysis of the various elements of cost involved in managerial decision making process like variable costs and fixed costs. The important aspects of relevant costs with respect to the decision of IT department of the company to be continued as an In-house operation or to be outsourced are also discussed as a part of this report. The financial implications of both the alternatives have been presented for the information of the management. The information is presented in tabular form with the necessary details of the calculations for arriving at the figures included in the tables. The report recommends the continuance of the IT department as an in-house operation in view of the distinct advantage arising to the company both in regard to the cost advantages as well as the qualitative factors which are in favour of the department functioning in-house. The relative merits and demerits of both in-house operations and outsourcing have been detailed as a part of this report for the information of the management References: 1. Charles T.Horngren, George Foster, Srikant M.Datar (2002) Cost Accounting: A Managerial Emphasis Edition X Prentice Hall of India Private Limited 2. Samuel L. Baker Cost Concepts Economics Interactive Tutorial [Online] Available from: http://hspm.sph.sc.edu/COURSES/ECON/Cost/Cost.html Accessed on 09th March 2007 . Word Count: Executive Summary: 237 Text including Executive Summary: 2212 Read More