How to Determine Outsourcing Costs

When someone first starts a business, odds are, they’re doing everything themselves; at first, it’s not even time to calculate outsourcing costs. But after the business grows a bit, the owner might find themselves wondering if it’s time to employ an outsourcing strategy. Maybe they want to keep labor costs low by outsourcing tasks like bookkeeping to an accounting firm. Perhaps they want to hire an assistant to handle basic administrative tasks, data entry, and payroll. Or maybe they just need some extra help to meet shifting market demands without hiring a new employee.

But how much will outsourcing cost? What are the hidden costs and direct costs of hiring an outsourcing provider? Do the benefits of those costs outweigh the risks?

This guide walks through the basics of how to calculate outsourcing costs through differential cost analysis. Differential cost analysis helps show business owners how outsourcing will impact their organization’s costs. It’s always wise to look at the differential costs instead of comparing the total costs of the status quo to those of outsourcing to an external partner. Differential costs help a person avoid accidentally including fixed costs that cannot be avoided by outsourcing, which could give the false impression of lower costs.

With this guide, small business owners can have an easier time determining their outsourcing budget by weighing the key factors that go into this crucial decision.

4 Steps to Calculate Outsourcing Costs

A sound cost-benefit analysis should account for direct, indirect, and opportunity costs and define the needed services, pricing models, setup costs, and ongoing operational costs.

Here are four key steps to help determine outsourcing expenses using a differential cost model and build a complete financial picture.

Recommended: Is Outsourcing the Right Option to Grow a Business?

1. Define the business function that will be outsourced

Generally, a business owner needs to specify both the function that will be outsourced and how much of that task will be handled by a third party. This helps an owner achieve a fair comparison between what can be reasonably handled in-house and what the external contractor is proposing. It should also reflect whether the company is outsourcing basic administrative work or specialized services, since more complex work typically costs more. For example, technology work such as cloud services usually costs more than routine support because it requires deeper expertise and stronger security controls.

Fully defining the scope of the outsourced project is essential. If a business owner doesn’t clearly define what the contractor will be doing and how much of it they’ll tackle, they can’t get a clear picture of how much it ought to cost. Without the right information, an owner could wrongly calculate their in-house costs as higher or lower than the actual cost of outsourcing, making it difficult to determine whether or not outsourcing will actually reduce costs.

2. Calculate those in-house costs that could be avoided by outsourcing

After a business owner clearly defines the business function that they’d like to outsource, their next step is to identify and calculate the costs their organization would avoid if it outsourced that function.

To start, a business owner can itemize all of the costs related to the task they plan to outsource. That includes the direct costs of the task, like the necessary supplies, training costs, employee salaries, payroll taxes, health insurance, account setup costs, and essential equipment. But it also includes indirect costs, like legal fees for contract negotiations, administrative tasks for filling that role, and other internal services related to it, such as quality control and vendor-management overhead (important tasks that matter more when outsourcing compared with keeping an in-house team).

Sunk costs should not be included in this calculation. Sunk costs are those expenses that have already been incurred and can’t be recovered, such as equipment that’s already been bought and can’t be returned. Office space that other employees use is another sunk cost that would need to be excluded. This decision-making process focuses on avoidable future costs.

With this information, a business owner can get a pretty clear picture of how much it costs to run that business function in-house. That can help guide their decision whether or not to pursue business outsourcing.

3. Calculate the total costs of business outsourcing

Now it’s time to calculate the total cost of outsourcing the chosen business function. Typically, these costs cover a contractor’s bid price, administrative costs for the contract, and the transition costs. But a business owner can also subtract the amount of money they’d gain by selling unneeded supplies, equipment, and furniture previously used for the now-outsourced tasks.

Administrative Costs

What are contract administration costs? Typically, these costs include all costs associated with the process of hiring and managing an outsourcing partner. For example, if a small business owner uses a platform like Upwork or Fiverr to hire a service provider for outsourcing, then administrative costs could include subscription fees for the platform, wages for the virtual assistant who evaluates the project bids, and setup fees for funding the account.

For larger outsourcing projects, administrative costs could include expenses related to requesting detailed proposals, evaluating them, writing and negotiating the contract, processing change orders and amendments (which might entail hidden fees and additional costs), monitoring the contractor’s performance, and more.

Transition Costs

Transition costs are the expenses incurred to make the switch to outsourcing, such as onboarding, data migration, and extra costs when both internal and external teams are working at the same time during the handoff. Transition costs also include expenses related to laying off the in-house team, including unemployment compensation and severance pay.

It’s even possible for work quality shortfalls to add to the overall expense of the transition; for example, there may be a few errors made by the outsourced team as they “learn the ropes,” so to speak. While those expenses might be minor in the long run, they’re essential to budget for. Hidden expenses can also come from knowledge transfer, legal compliance, and penalties for contract changes, and these unexpected expenses should be documented in the outsourcing agreement to reduce disputes.

In some scenarios, the financial benefits of outsourcing services are outweighed by the costs of paying severance to the employee who does the work.

4. Make the cost analysis: Deduct the costs of outsourcing from in-house costs

The final step is to calculate the difference between the potential costs saved from outsourcing and the costs incurred when outsourcing. If results show that outsourcing has high potential savings, then a business owner can generally justify proceeding with outsourcing.

Some business owners find it helpful to use an outsourcing cost calculator for these calculations, but it’s absolutely possible to DIY these pricing models with a reasonable degree of accuracy.

To help illustrate this concept, here are some tables that illustrate a simple differential cost analysis.

Conclusion

Every business owner will need to make a judgment call about whether or not outsourcing is a good idea for their company. In some cases, outsourcing can improve efficiency and save money, but in other cases, the actual expenses can be higher. With the right research, business owners can carefully evaluate whether the final cost benefits are worth making the switch.

Good luck with outsourcing!

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