A. When to Use Fully Allocated Costs

As noted earlier, the total cost, or fully allocated cost of providing a target service in-house is the sum of its direct and overhead indirect costs. Cost comparisons using fully allocated costs are useful in determining if the in-house cost of providing a target service is comparable with private-sector market prices.[24] The state of Texas, for example, routinely compares the fully allocated cost of in-house service delivery with private-sector market prices. If the fully allocated cost of in-house service delivery is greater than 110 percent of the prevailing private-sector market price, the state agency must reduce its costs within a specified period of time or the service may be targeted for contracting out. In addition, it may be appropriate to consider fully allocated costs when comparing the operating efficiency of service delivery before and after privatization. For example, if prior to privatization the per-household fully allocated unit cost of public garbage collection was $9, compared to total private-contracting costs of $6, these figures may be used to reflect the relative operating efficiency of public and private service provision. These figures do not, however, necessarily reflect the cost savings that will be realized through privatization, for reasons explored in the next section.[25]

B. When Not to Use Fully Allocated Costs

The use of fully allocated costs is generally inappropriate in estimating the savings to be realized by contracting out a target service that is currently being conducted in-house. In other words, the amount of money that is likely to be saved is not simply the difference between fully allocated in-house costs and the total contracting cost. This is because contracting out does not generally result in a dollar-for-dollar reduction in governmental overhead costs. For example, the contracting out of a target service, or a portion thereof, may result in decreasing the workload of service departments like personnel, finance, and facilities management but the workload reductions may be insufficient to have any significant effect on the costs of maintaining these departments. When attempting to determine the potential cost savings associated with the contracting out of a target service, the appropriate in-house costs to use in the comparison are the "avoidable costs"; these are defined in the next section.

C. Avoidable Costs

Avoidable costs are those in-house costs that will not be incurred if a target service, or portion thereof, is contracted out.[26] How-to contracting books,[27] as well as several contracting-out guides prepared by state and local governments,[28] recommend the use of avoidable costs when assessing the likely cost savings achievable through contracting out. The use of avoidable, or incremental, costs is also the generally accepted managerial accounting approach to conducting the financial component of a business "make-or-buy" decision.[29] Determining which in-house costs are avoidable is not a simple task. Of course, virtually all direct costs will be avoidable. But ascribing what portion of overhead costs are avoidable is a matter of judgment, and depends largely on three factors:

  1. The determination of the public sector to reallocate resources efficiently;

  2. The extent of the privatization effort, both in the target service area and in other services that employ the support of the same government departments; and

  3. The time period in-which resource allocation is expected to occur.

RESOURCE REALLOCATION

In the private sector, the decision to discontinue a particular function is usually accompanied by a swift reallocation of resources in support areas as well. For example, a company that eliminates a product line that accounts for 30 percent of sales will not only eliminate those positions directly involved in manufacturing that product, but is also likely to reduce the size of support staff—such as personnel, procurement, accounting, etc.—by something approaching 30 percent. The private sector has a strong incentive to reduce overhead as much as possible. The public sector lacks such strong incentives, and the extent to which overhead costs can be avoided in the wake of contracting out is partly a function of political will.

EXTENT OF PRIVATIZATION

The reduction in overhead costs is related to the extent of the privatization, as illustrated in the janitorial example presented below. There is a cumulative effect to be considered, in that contracting out not only in the target service but in other services which make use of the same overhead support functions influences the potential for overhead reduction. For instance, contracting out a service with only five employees would be unlikely to reduce overhead by any appreciable amount, unless several other small programs were also being contracted out as well. Several small contracts, which considered separately would have a negligible impact on overhead, could in the aggregate reduce overhead significantly.

TIME FACTOR

There are many costs that cannot be avoided in the short term that may be avoidable in the long term. For example, contracting out of a portion of transit service may leave a public entity holding a lease for more storage and maintenance capacity than is necessary. In the short term, that cost may be unavoidable, but in the long term the public entity could decline to renew the lease. Similarly, there may be instances in which contracting out leaves a public entity over-staffed but legally obligated not to lay off workers. In the short term, this represents an unavoidable cost, but in the long term, staff levels could be reduced to efficient levels through attrition.

Avoidable costs can never exceed fully allocated costs. You can never avoid more than the service currently costs to provide. Over the long term, however, an organization should reconfigure itself so that overhead is adjusted downward to an efficient level. MIT's Jonathan Richmond has written that "in the longer term, as a general rule... marginal costs approach and converge with fully allocated total costs."[30] In this way, fully allocated costs can be thought of as the long-term theoretical upper limit of avoidable costs.

This emphasis on avoidable costs does not mean that computing the fully allocated costs of providing a target service in-house is a superfluous exercise. In order to determine the costs to be avoided by contracting out, the fully allocated costs of in-house service delivery must first be determined. And, as mentioned previously, fully allocated costs are appropriate when comparing operating efficiencies of the public and private sectors.

In all cases, the sought-after figure when estimating cost savings should be:

Avoidable Costs - Total Contractor Costs
= Cost Savings


D. Cost Comparisons Using Fully Allocated Costs and Avoidable Costs: Two Scenarios

The rationale for using avoidable costs when evaluating likely cost savings from contracting is perhaps best explained by a pair of examples. Table 3 compares the fully allocated costs of providing in-house Janitorial services at a 10,000 square feet county government facility with the costs that will actually be avoided if the county decides to contract out.

Table 3

SCENARIO ONE: COMPARISON OF FULLY ALLOCATED COSTS AND AVOIDABLE COSTS

Cost Item

Fully Allocated Costs

Avoidable Costs

Direct Costs

 

 

     Salaries and wages

$20,000

$20,000

     Employee benefits (@ 21.25%)

$4,250

$4,250

     Supplies

$2,000

$2,000

     Total Direct Costs

$26,250

$26,250

Indirect Costs

 

 

     Division overhead

$11,520

0

     Branch overhead

$1,683

0

     Department overhead

$4,452

0

     Countrywide overhead

$2,792

0

     Total Indirect Costs

$20,447

0

Total Direct and Indirect Costs

$46,697

$26,250

Cost per square foot

$4.67

$2.63

Source: Joseph T. Kelly, Costing Government Services: A Guide for Decision Making, (Washington, D.C.: Government Finance Officers Association, 1984), p. 107, used with permission.

In this scenario, the county has received a responsive bid from a responsible bidder in the amount of $32,500, or $3.25 per square feet to provide janitorial services at the facility for a period of one year.

The county has an automated accounting system capable of identifying, tracking and allocating overhead costs and developing overhead rates for its various management levels. The overhead rates in ascending order are: division level (57.508%), branch level (8.413%), department level (22.259%) and countywide level (13.957%). These overhead rates are applied to a base of salaries and wages. The question is: will the county reduce the cost of janitorial services at the 10,000 square feet facility by contracting out?

As Table 3 illustrates, the fully allocated costs of providing janitorial services in-house at the 10,000 square feet county facility for a period of one year consist of $26,250 in direct costs (salaries, wages and benefits of 2 custodians and an allowance of $2,000 for supplies) plus $20,447 in allocated overhead costs for a total of $46,697 or $4.67 per square feet. When the in-house cost ($4.67 per square feet) is compared to the bid price of $3.25, it appears that the county can reduce service delivery costs by $1.42 per square feet, or $14,200, by contracting out. This estimate of cost savings however is illusory as the avoidable cost analysis demonstrates.

If the county contracts out in this scenario, only the direct costs ($26,250) of in-house service delivery will actually be avoided. No overhead costs will be avoided because the amount of in-house janitorial activity being contracted out is too marginal to affect overhead costs. Only the $2.63 per square feet of direct costs will be avoided, but $3.25 per square feet (the contractor's bid) in new costs will be incurred. Thus, in this scenario, contracting out will actually increase, rather than reduce, service delivery costs. For contracting out to be justifiable purely on the grounds of reducing service delivery costs, the amount of existing in-house costs to be avoided must be greater than the new costs of contract service delivery that will be incurred. One can properly conclude that the greater the proportion of an in-house service targeted for contracting, the greater is the potential impact on overhead cost, and thus the greater the potential to reduce service delivery costs,

Table 4 presents a second contracting-out scenario where the county is contemplating contracting out all in-house janitorial services. The contract would involve 1,691,500 square feet of county facility space, and the contractor's bid is again computed at $3.25 per square feet for a period of one year. In this scenario, all direct costs associated with in-house delivery of janitorial services will be avoided. Additionally, all division and branch overhead will be avoided because these supervisory and operational support levels, with their attendant costs, will now be the responsibility of the contractor. Also, a significant proportion of department and countywide overhead costs-but not all-will be avoided because these management levels will no longer be required to provide services (e.g., personnel, finance, facilities management, etc.) in support of the janitorial function. (As mentioned previously, contracting out of non-janitorial functions that make use of the same support overhead would have the same effect.) The total costs to be avoided in this scenario will be slightly in excess of $6 million or $3.55 per square feet. The contractor's bid is $3.25 per square feet. Thus, contracting out will result in avoiding 30 cents per square feet, or $507,450.

Table 4

SCENARIO TWO: COMPARISON OF FULLY ALLOCATED COSTS AND AVOIDABLE COSTS

Cost Item

Fully Allocated Costs

Avoidable Costs

Direct Costs

 

 

     Service Provision Salaries and wages

$2,145,817

$2,145,817

     Employee benefits (@ 21.25%)

$455,986

$455,986

     Service and Supplies

$950,000

$950,000

     Subtotal

$3,551,803

$3,551,803

Division Overhead

 

 

     Salaries and Wages

$1,017,745

$1,017,745

     Employee Benefits

$216,271

$216,271

     Subtotal

$1,234,016

$1,234,016

Branch Overhead

 

 

     Salaries and Wages

$219,506

$219,506

     Employee Benefits

$46,645

$46,645

     Subtotal

$266,151

$266,151

Departmental Overhead  (@22.259%)

$753,057

$600,000

Countrywide Overhead  (@13.958%)

$472,209

$350,000

Total Cost

$46,697

$26,250

Cost per square foot

$3.71

$3.55

The cost comparison analysis between in-house and contract service delivery is still not complete. Contract administration costs and one-time conversions costs must be added and off-setting revenues subtracted to arrive at the total cost of contract service delivery. Even after these costs are included in the analysis, however, this scenario would likely result in the county saving several hundred thousand dollars by contracting out all Janitorial services.