Comparing Costs between Internal and Outsourced Services

Presenting a budget that lists the cost of an internal service provider’s deliverables, rather than internal expense factors, is the first step to making an “apples to apples” comparison with an outsourcing vendor’s proposal.


Once the “budget-by-deliverables” approach is implemented, another problem becomes evident: Internal staff does things that outsourcing vendors do not (and should not) do.


Specifically, there are two types of deliverables that internal staff delivers and outsourcing vendors don’t. I call them “subsidies” and “venture capital.”


Subsidies are ongoing activities done for the common good (to benefit any and all clients), which competitors don’t do.


Given their dedication to the same shareholders, staff people are asked to perform some services on behalf of the firm as a whole.


An example of a subsidy is commodity-product research and advice (a “consumers’ report”). For example, in IT, staff may research the best configurations of personal computers for various uses. This research helps clients make the right choices, whether they buy PCs through internal staff or directly from a vendor.


Other examples include policy and standards coordination, community-action programs and corporate task forces.


These “corporate good” activities should never be delegated to vendors who have different shareholders’ interests in mind.


Venture capital is temporary funding to start new lines of business or make significant enhancements to the organization’s competitiveness. It’s a deliverable that benefits the internal service provider, not its clients.


Examples of costs that should be funded by venture capital include additions to infrastructure, start-up costs for new lines of business, and transformational activities such as redesigning the organization for high performance.


In a marketplace, these activities would be funded by banks and shareholders, not built into the price of other products and services. The banks and shareholders expect a return on their investment; of course, the mortgage payments to repay these loans would be embedded in the price of the company’s services.


Internally, many internal service providers either have no source of funds for infrastructure and new ventures, or are expected to recoup the full price of ventures in their current-year budget and rates. This puts them at a serious competitive disadvantage.


In a budget-by-deliverables, subsidies and venture capital are highlighted as separate deliverables. Their costs are not buried within the price of other deliverables.


Understanding subsidies and venture capital is particularly critical during an outsourcing study. If subsidies and venture capital aren’t separated from the cost of competitive products, the external service provider may win the business even though its true unit costs are higher.


Funding subsidies and venture capital separately permits a fair comparison with competitors of the prices of specific products and services. It separates the outsourcing decision (which focuses on ongoing products and services) from the decision to invest in corporate-good endeavors and to loan the internal service provider capital that’s repaid through depreciation.


Separating subsidies and venture capital also encourages a thoughtful decision process around each such activity, leading to an appropriate level of corporate-good and reinvestment efforts. On the other hand, if such costs are hidden (as they are if buried in the organization’s prices), then there’s a good chance that the firm will demand more and more of these apparently “free” services, and the internal organization’s costs will rise.


Once executives compare “apples to apples,” the internal service provider may very well offer a competitive deal.


While the logic of budget-by-deliverables is straightforward and compelling, the mechanics require careful thought. Identifying an organization’s products and services — not tasks, but deliverables — is itself a challenge. The level of detail must be carefully managed so that each budget row in the spreadsheet represents a meaningful client purchase decision, without inundating clients with more than they can comprehend.


Once the rows are identified, allocating myriad indirect costs to a specific set of deliverables is a challenge in “activity-based costing.” Many have found an activity-based costing analysis difficult for just one or two lines of business. To prepare a budget-by-deliverables requires a comprehensive analysis across all products and services. This adds unique problems, such as “circles,” where two groups within the organization serve one another, and hence each is part of the other’s cost structure and neither can determine its price until the other does.


Fortunately, there is a step-by-step process that makes it practical to identify and cost all of an internal service provider’s products and services. This process makes internal rates transparent and defensible, and leads to a clear counter-proposal.


The result of the budget-by-deliverables process is a proposal that estimates the true cost to shareholders of each staff deliverable, making for fair (and, one hopes, favorable) comparisons with outsourcing vendors’ proposals.


Useful Links:




How An Internal Team Can Respond to an Outsourcing Challenge

Learn more about the mechanics of budget-by-deliverables:


Learn more about how to identify and cost out internal service provider products and services: