Outsourcing
Outsourcing is contracting an activity to an external provider instead of performing it in-house, decided by comparing the relevant (avoidable) cost of making it against the cost of buying it, alongside quality and control factors.
What it is
See it move
A firm makes 4,000 units in-house at €12 variable cost each, €48,000, plus a €10,000 avoidable supervisor salary, a relevant cost of €58,000. An external supplier quotes €13.50 per unit, €54,000. Outsourcing lowers the relevant cost by €4,000 — but only because the supervisor cost is genuinely avoidable; unavoidable costs like factory rent are excluded.
The formula
Variables
- Net saving from outsourcing (€)
- Relevant (avoidable) cost to make in-house (€)
- Relevant cost to buy externally (€)
Compares only the costs that change between making an activity in-house and buying it externally; a positive S means outsourcing lowers relevant cost.
Check yourself
A firm currently makes 2,500 units in-house at a variable cost of €9 per unit, plus €6,000 of supervisor costs that would be entirely avoided if the part were outsourced. An external supplier offers to supply all 2,500 units at €10.80 each. What is the net financial effect of outsourcing?