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Kee, R. 1998. Integrating ABC and the theory of constraints to evaluate outsourcing decisions. Journal of Cost Management (January/February): 24-36.

Summary by Hanna Morales
Master of Accountancy Program
University of South Florida, Summer 2002

ABC Main Page | Outsourcing Main Page | TOC Main Page

Kee illustrates the advantage of using ABC and Theory of Constraints (TOC) together to evaluate whether to outsource or not, if so, when, and why it is more practical to outsource rather than produce.

Outsourcing is the purchase of components and services from external suppliers. Before deciding to outsource, the activities used in production are examined to determine if the products should be made internally or bought from suppliers. The components to be produced are classified as either strategic or commodity.

Strategic components represent the organization’s core competencies such as, knowledge of product design and manufacturing skills. Because of these components the company is able to differentiate its products and provide a cost advantage putting the firm in a more competitive position and enhanced financial performance (24). Companies have long-term commitments to strategic components. Also, non-financial considerations determine whether to outsource it or not (27).

On the other hand, there are the commodity components. Accurately estimating production cost plays a major role in settling whether to outsource these types. They offer neither differentiation nor better competitive or financial position from those of the competitor’s. This type may be purchased from more cost-efficient suppliers, enabling the firm to focus its capital and human resources more on strategic activities (24).

To further explore on commodity components, Kee presented four cases (Exhibit 1) in which the relationship between a supplier’s price and the product’s short- and long-run production costs are factors in determining whether to outsource or not. This is where the role of accounting information system becomes prevalent. The systems used measure the economic consequences (in terms of production costs) of resource-allocation decisions (27). In this article, Kee spoke of two: ABC and TOC.

Exhibit 1: Outsourcing Cases
Case Component Type Relationship of
Supplier's Price
to Company's
Production Cost
Outsourcing
Implications
1 Commodity Price < short-run cost
Price < long-run cost
Outsource short-run
Outsource long-run
2 Commodity Price ≥ short-run cost
Price < long-run cost
Produce short-run
Outsource long-run
3 Commodity Price < short-run cost
Price ≥ long-run cost
Outsource short-run
Produce long-run
4 Commodity Price ≥ short-run cost
Price ≥ long-run cost
Produce short-run
Produce long-run
5 Strategic Price < long-run cost Evaluate further
6 Strategic Price ≥ long-run cost Produce

ABC traces indirect cost-to-cost objects based on factors or cost drivers (may be multiple) that cause or correlate highly with indirect costs on the basis of the structural level at which costs are incurred in the production process. However, it does not support short-term decisions, thus a company is unable to adjust its expenditures for resources that are and have already been contracted in advance, for instance. Furthermore, it fails to incorporate the cost of using the most constrained activity, bottleneck, in which Kee cited Goldratt, who indicated that any system must have at least one constraint that restricts the company’s ability to achieve its goal.

TOC, in contrast, incorporates bottleneck activities. The objective is to maximize throughput, which is defined as a product’s price less the cost of direct material used in its production. TOC has been criticized for not supporting long-term economic decisions; its main focus is on optimizing the company’s short-term performance. Kee then, suggests combining the two since their strengths are complementary in nature. They reflect the economic consequences of resource-allocation decisions over different time horizons (short and long-term). Likewise, TOC measures the incremental and opportunity costs of production in the short-run and ABC reflects the costs the company may expect to incur in the long run (28-29). According to Kee, together they can be used to measure a component’s short- and long-run production costs. They can be used to determine if outsourcing a commodity component is economically feasible, when it is so, and why (36).

The formula used to figure the results in Exhibit 1 is taken from Exhibit 2 below. Case 1 demonstrates that the purchase price for outsourcing is less than both short and long-run costs, so it would be more economical to outsource in both the short and long-run and use the opportunity to focus more on the organization’s competitive position. Similarly in Case 4, when the purchase price was greater than the costs, it would be wiser to produce for both time frames.

Exhibit 2 - Short-Run; Long-run, And Purchase Cost
Short-run cost Case 1 Case 2 Case 3 Case 4
Opportunity Cost $360.00 $45.00 $90.00 $270.00
Direct Material Cost 20.00 15.00 15.00 60.00
TOC Cost 380.00 60.00 105.00 330.00
Labor and Overhead 30.00 10.00 15.00 25.00
Total 410.00 70.00 120.00 355.00
Long-run Cost        
ABC Cost 215.70 100.43 63.69 234.95
Purchase Price 200.00 90.00 80.00 400.00

In the case of strategic components, Case 1 and 4 may still be applied, as Case 5 and 6, but more thought and evaluation is involved with the analysis. If the decision is to outsource (Case 5), before doing so, the company should first identify the risk involved in purchasing a strategic component. The company must identify the core competencies underlying a component and formulate how to maintain them under outsourcing for example, they must prevent the vendor from taking the knowledge gained through outsourcing and becoming a competitor (34). If the decision is to continue producing, as in Case 6, analysis of the core competencies, the activities, and costs may be used to stimulate organizational learning and change needed to maintain the company’s cost advantage. The difference between the cost and price should be used to stimulate a program of process improvement. The objective would be to focus on improving the efficiency of the production processes used in production of those components (35).

In Cases 2 and 3, the analysis is more focused on time horizon when to change strategies. An important aspect of implementing outsourcing (Case 2) is to determine when the component should be produced. Failure to identify when to stop producing and begin purchasing is critical for preventing making short-term decisions leading to producing the component over an extended time period. In the same way with Case 3 in which the component should be outsourced in the short-run because the resources used in its production can be used more profitably to produce other products. The company then, must determine the time frame when to purchase the component. Failure to do so can lead to a series of short-run decisions resulting in purchasing it long-term (32-33).

With these examples, the importance in combining the two systems is obvious. Kee adds in the article a situation in which Case 2 used TOC and ABC separately. If TOC were solely used, the company would produce the component over the short term and make a series of short-term decisions that could lead to producing the component over an extended time period. Using ABC alone could lead to outsourcing the component immediately, even though it is more economical for the company to continue producing the component in the short run (34). Therefore, ABC and TOC are more beneficial if used together than alone in making outsourcing, resource-allocation decisions.

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