Who is feeding the outsourcing movement

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You can think of outsourcing everything, including yourself. How do you outsource yourself? You can become a vendor that provides services to your company on a contract basis instead of being an …

You can think of outsourcing everything, including yourself. How do you outsource yourself? You can become a vendor that provides services to your company on a contract basis instead of being an employee. That is extreme, but possible. The other extreme is where the company employs everyone and makes everything. Now, this is extreme and impossible. Can a company make its own photocopiers? And coffee maker? Remember the old make or buy economic question? Exciting micro-economic analysis exercise back then. Now it’s a really life question – in-house or outsource?

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  • 1. Who is Feeding the Outsourcing Movement 2nd Edition
  • 2. Who is Feeding the Outsourcing Movement Page 2 of 10
  • 3. Contents CHAPTER 1 The Business Model as We Know It………………………………………………………...…. 4 Improving Your Break-Even Point……………………………………………………...…….. 5 Getting Rid of Fixed Costs…………………………………………………………………… 6 We all must become economic adults! ………………………………………………………… 7 What is it all about? ……………………………………………………………………………. 7 CHAPTER 2 Case Study………………………………………………………...……………….…………… 8 The Devil is in the Details………………………………….…………………………….……. 8 Conclusion………………………………………………….….…..…………………………… 9 About the Author………………………………………….….………………………………… 10 Acknowledgement I wish to thank James Skinner, Roice Krueger, and Mark Victor Hansenideas for some of the insights in their eBook Chronic Profitability. Page 3 of 10
  • 4. CHAPTER 1 The Business Model as We Know It When we talk about costs in business, we distinguish between fixed costs and variable costs. A fixed cost is a cost that you incur whether you conduct any business or not. If you have rented an office, that is a fixed cost. It does not matter from the property owner’s perspective whether you do any business or not; they are going to get their rent. In traditional economic theory, when we want to find out how healthy a company is we calculate what is called the Break-Even Point (BEP). Sales/Costs Graph A Output (Units) Here is the formula: BEP=FC/(1-VC/S) Or BEP = FC/(unit S - unit VC) when we are more interested in quantities, not dollars. Where, FC is Fixed Cost, VC is Variable Cost and S stands for Sales. The break-even point is therefore equal to the fixed costs divided by 1 minus the variable costs percent divided by the sales. Suppose we have a company that has the following profile: $ $ 1,200,000 300,000 1,500,000 450,000 200,000 90,000 740,000 Sales (1 000 000 units @ $2.30/unit) Variable Costs Production Expenses (1 000 000 units @ $1.20/unit) Direct Selling Expenses (1 000 000 units @ $0.30/unit) Fixed Costs Administration Expenses Financing Expenses Sundry Expenses $ 2,300,000 2,240,000 60,000 Net Profit Page 4 of 10
  • 5. Here, the company’s variable cost ratio is VC/S = 65.22% or, to put it another way, they have a profit ratio of (1 – VC/S), i.e.34.78% on each sale made. To calculate the break-even point, all we have to do is divide $740 000 (the amount of fixed costs) by 34.78% (the profit margin on each sale). The break-even point for this company is therefore $2 127 500. If this company has sales of $2 127 500, then they will be breaking even; they can pay their fixed costs and their variable costs. That is their break-even point. Looked at another way, the quantities view, the break-even point is $740 000/ ($2.30 - $1.50) units, i.e. $740 000/$0.80 which gives us 925 000 units. At $2.30 per unit this is the same sales figure of $2 127 500. Now, suppose we shift 31% of FC to VC, what happens now? Let’s see. The new FC is $740 000 - $229 400 = $510 600. VC goes up by the same amount from $1 500 000 to $1 729 400 (i.e. from $1.50 to $1.73 per unit). And the new break-even point is:$510 600/ ($2.30 - $1.73) = $510 600/$0.57 = 894 737 units. At $2.30 per unit this gives us a total sales break-even point at $2 057 895. At the same unit price, we only have to sell 894 737 units to break even, down from 925 000. Improving Your Break-Even Point What this formula tells us is that if you want a very good business, you want the break-even point to be very low. Then you don’t have to get that many sales before you start making money. To achieve that, what you need to do is decrease the fixed costs. If you can take your fixed costs and turn them into variable costs, your break-even point will go down. Converting fixed costs into variable costs will improve your break-even point. If you have no fixed costs, what is your break-even point? Zero! So that makes it very simple. If you do not have any fixed costs, you can’t lose any money. Check Graph A above: When fixed cost is zero, the total cost curve pivots to coincide with the revenue curve. If you just sit there and do nothing, you are not losing any money just as you are not making money. Now that is why everybody is thinking about outsourcing. Outsourcing converts fixed costs to variable costs, improving your company’s break-even point. When you outsource rather than pay somebody in-house to do it, which is a fixed cost, it now becomes a variable cost. Therefore, if your sales go down, your head still manages to remain above the water. Remember, it is against the law to reduce someone’s salary because “sales have gone down”. Put simply; the lower your fixed costs, the higher your profitability. Therefore, you want to start thinking about ways to decrease your fixed costs. Page 5 of 10
  • 6. Fixed costs going down is a good thing. It lowers your break-even point and improves profitability. The trend of the business world today is that fixed costs are out. Getting Rid of Fixed Costs Let’s do some thinking exercise. How can we get rid of the fixed costs? What can we do? Outsource, of course. You can think of outsourcing everything, including yourself. How do you outsource yourself? You can become a vendor that provides services to your company on a contract basis instead of being an employee. That is extreme, but possible. The other extreme is where the company employs everyone and makes everything. Now, this is extreme and impossible. Can a company make its own photocopiers? And the coffee maker? Remember the old make or buy economic question? Exciting micro-economic analysis exercise back then. Now it’s a really life question – in-house or outsource? It is not just other people who can be vendors; you can be a vendor, a consultant. I believe that in the future, everyone will be an independent vendor. We are moving from a dependent paradigm to an independent and interdependent paradigm. In the future, every individual will be their own business. Their own boss! The dependent paradigm is the paradigm of parent and child, which says, “I will take care of you, but you must do what I say.” This is the traditional paradigm of the employee/employer relationship. Do you know what they call the employee/employer relationship in the law? The law of masters and servants. Yes. Until very recently we had a statute styled Masters and Servants Act in Zimbabwe! Is that shocking? Reserve your shudders for the future. We are moving away from a masters-andservants paradigm. The reason is that companies can no longer be the parent, because of global competition and destructive innovation. The fact is technology is advancing so rapidly that entire industries now become irrelevant and can no longer guarantee they can take care of you forever. Industry says, “You know we can work together while it is profitable to do so, but I don’t know what is going to happen three years from now. I really don’t. We could be in the business of making telephone handsets, and somebody could invent a cell phone. We could become completely irrelevant, and in this case I can’t take care of you. Peter Drucker, the renowned management guru, surmised that the average life span of the modern business corporation is less than 20 years. Employment for life (the Japanese have a name for it) – not unless your work life is 15 years! So we now need to be independent. You need to be able to take care of yourself. But we can work together, which is called interdependency. We can work together while it is profitable for us to do so. We are moving to a different paradigm.” Page 6 of 10
  • 7. You need to be independent, because now we are all outsourced! Now, if the company is the parent and the parent is becoming less stable, then the child cannot depend on the parent, so the child must quickly become independent, meaning that they can provide for themselves. The company is required to outsource, and the child must become independent. Yes, we all must become adults very, very quickly now. We must become economic adults who are able to be responsible and work together in a responsible manner. The social contract has shifted, for better or worse. I am merely describing the world as we work and live in it. Everyone is headed for self economic empowerment. So we can say to all and sundry “I ‘m doing my own thing”! We all must become economic adults! Now what other ways can you reduce your fixed costs? Outsourcing is not the only way. Think hard. You can reduce your rent, downgrade your offices. You know, Peter Lynch, one of the greatest US stock investors, says that when he goes to visit a company and it is in very flashy offices, he runs for the door. Why? Because they have got to work really hard just to pay the rent. You are not in the business of making your landlord wealthy. You are in the business of making you and your shareholders and your employees wealthy. That is another way to decrease fixed cost. How else can you do it? How many copiers do you have in your company? How much is your monthly spend on the toner cartridges, on servicing, on the copying staff? You get my drift: Outsource equipment use. Just let the clerks dash across to do photocopies at Betty’s print and photo shop across the street and you won’t have to waste money holding “workshops” to lecture staff on reducing unnecessary paper. See how many birds you are killing here with one stone! The variable cost stone of outsourcing. We do have real leverage here. How else can you get rid of your fixed costs? You can downsize and get rid of all your fixed costs entirely. Which fixed costs? Salaries. So what other way can you take a fixed salary cost and turn it into a variable cost? You can pay your people in stock options—which are only going to be valuable if your people make you a bunch of money. Or you can give them a commission or a percentage of profits. You can create a larger bonus pool and a lesser salary, but then the bonus pool depends on the profits. So unless you are profitable, you don’t have to pay them. Would that increase your profitability, yes or no? Yes. You have to have many ways to do it. What is it all about? What I am saying is that the Adam Smith economic model which has shaped the world as we know it is on its way out. So, next time you hear a politician talk about “full employment”, please just do look him/her straight in the eye and move on! Page 7 of 10
  • 8. CHAPTER 2 Case Study HARARE, Nov 20, 2013 (The Herald/NewsDay) - TN Harlequin is set to close down most of its factories, some of its shops and significantly reduce its workforce as the company responds to massive decline in demand of its products. CE of TN Lifestyle Holdings, which owns TN Harlequin, Tawanda Nyambirai, also said the group would “with immediate effect” sell some of its properties to raise money to fund the retrenchment exercise and pay outstanding salaries. TN Harlequin furniture sales have dropped from between US$1,8 million and US$2,1million per month to between US$500 000 and US$800 000 per month. But the costs have remained more or less the same. Nyambirai said management is currently discussing the feasibility of closing down, or significantly down scaling some of these operations, but it would commence the disposal of properties to ensure early payment of the exit packages and arrear salaries. The company employs over 1 000 workers The Devil is in the Details Let’s look at the hypothetical, albeit realistic, situations depicted in the two tables below. TABLE A: ANNUAL COST OF AN IN-HOUSE INTERNAL AUDIT DEPARTMENT Annual Cost Gross Salary Implied Rent: Office [two rooms] Motor Vehicle Internet Fuel [$40 per week] Medical Aid Annual Leave Telephone Annual Bonus [thirteenth cheque] HR Admin [PAYE, NASA, processing] Total [4 Auditors] Total [3 Auditors] Total [2 Auditors] Total [1 Auditor] Internal Audit Manager 30,000 Internal Auditor A 24,000 Internal Auditor B 18,000 Internal Auditor C 18,000 400 400 400 Total 90,000 1,200 18,000 360 2,000 50 2,500 1,200 2,500 2,400 18,000 1,440 2,000 185 7,500 3,000 7,500 360 360 360 45 2,000 600 2,000 45 1,500 600 1,500 45 1,500 600 1,500 120 120 120 120 480 57,930 57,930 57,930 57,930 29,525 29,525 29,525 22,525 22,525 22,525 132,505 109,980 87,455 57,930 etc. Page 8 of 10
  • 9. TABLE B: ANNUAL COST OF INTERNAL AUDIT SERVICES OUTSOURCED TO 5WH Internal Audit Manager 30,000 Internal Auditor A 24,000 Internal Auditor B 18,000 Internal Auditor C 18,000 0 0 0 0 0 0 0 0 150 0 0 0 150 0 0 0 150 0 300 0 0 0 0 0 750 0 0 0 0 0 0 30,600 30,600 30,600 30,600 24,150 24,150 24,150 18,150 18,150 18,150 91,050 72,900 54,750 30,600 Annual Cost Gross Salary Implied Rent: Office [one room part time] Motor Vehicle Internet Fuel Medical Aid Annual Leave Telephone [one extension part time] Annual Bonus [thirteenth cheque] HR & Admin [PAYE, NASA, etc. processing] 300 0 0 0 0 0 300 0 Total [4 Auditors] Total [3 Auditors] Total [2 Auditors] Total [1 Auditor] Total 90,000 The first table, Table A, portrays the cost profile of an in-house Internal Audit Department. The table shows a department of 4 auditors having an annual running cost of $132 505 (Manager $57 930, Auditor A $29 525, Auditor B $22 525, Auditor C $22 525) in salaries and auxiliaries. Table B, on the other hand, shows a different picture. The annual running cost falls by 31% to $91 050. Now, the figures may be hypothetical but the premise is fact: By way of illustration, our fee at 5wh 1is just the Gross Salary portion of the total cost, or deemed total cost, of running an in-house Internal Audit Department. This is 5wh strategic proposition. By outsourcing, not only have you transferred FC to VC but you will have also transferred the auxiliary costs to the outsource partner. The leverage of outsourcing! Conclusion We have seen that the lower an organisation’s fixed cost, the more nimble it is and the more profitable it can be. One effective way of lowering fixed cost is moving as much of it as is feasibly possible to variable cost. With smart contractual arrangements, outsourced services can result in the transformation of salaries (fixed cost) to, in the above example, Internal Audit fees (variable cost). 1 FiveWH Corporate Services (Private) Limited (“5wh”). 5wh denotes the six open-ended questions; What? When? Where? Who? Why? and How? Page 9 of 10
  • 10. Secondly, the extensive auxiliary costs of running an in-house department (at least 31% in our example) are eliminated. Some of these costs (such as opportunity cost) cannot be quantifiable in conventional accounting terms. Finally, the situation described in our Case Study (a true story) makes sad reading indeed. Here TN Lifestyle Holdings were to sell some of their real estate properties to raise money “to fund the retrenchment exercise and pay outstanding salaries”. The statement “But the costs have remained more or less the same” sums up the pain associated with a high overhead overhang. Needless to say, retrenchment and outstanding salaries do not feature in an outsourced ecosystem. Thanks About the Author Caleb Mutsumba Caleb is a Registered Public Accountant with experience in: Internal Auditing, Fraud Investigations and Forensic Auditing, Fraud Risk Management, Criminal Justice processes, Caleb has worked for various public and private sector entities for more than twenty years. Upon leaving the Internal Audit department of a major commercial bank in 2001, Caleb joined Ernst & Young to head the newly formed Forensics Department. He left Ernst & Young in 2007 to establish 5wh 2 Corporate Services . He can be reached at caleb@zol.co.zw and +263 772466540. 2 Five WH Corporate Services (Pvt) Limited (“5wh”) is a dynamic, relationship-oriented professional services company that provides the following solutions: Internal Audits Forensic Audits Compliance Audits Business Systems Design, Development and Reviews Page 10 of 10