In calculating the direct costs of hourly employee labor to determine
whether to terminate employee, outsource to contractor, or what amount
to adjust revenue-per-man-hour goals, should the tax deduction for the
expenses be used to lower the total cost.  If our tax rate is 30%,
should we reduce the line items that are claimed at the end of the
year for this expense by this amount in order to come to a more
accurate figure.  If $500 is our total cost of labor would it be more
accurate to say the true cost after deductions is $350 when
determining profitability or comparing costs to outsourcing etc.?

As gspindia suggests, an after-tax cash flow analysis is a good way to
evaluate the outsourcing decision.  However, all factors that impact
cash flow both now and in the future need to be evaluated in order to
assure a comprehensive analysis.  You need to evaluate every variable
cost associated with each option, and also consider "fixed" costs if
they become adjustable as a result of the outsourcing decision.  There
is also a strategic component to the decision to be considered.

For an employee, you have variable costs associated with cash
compensation, insurance, retirement plan contributions, stock options
and/or grants, payroll taxes, car allowances, and any other direct
cash expenses.  Subtract any tax benefits resulting from these
payments to result in net cash costs associated with the employee.

If you are considering outsourcing only a few employees, then fixed
costs are probably unaffected.  However, when you begin to consider
outsourcing a significant number of employees, then you might be able
to eliminate facilities and equipment if the company you are
outsourcing to is providing facilities.

For a contractor, you have variable costs associated with cash
compensation primarily, but you also must consider expenses associated
with training and equipment, if any, that would be needed. 
Furthermore, there is nearly always some loss of productivity, at
least initially, whenever personnel are changed.  Ideally you would
like to reduce all of these items to a cash cost on an after-tax
basis.

Finally, there are other considerations.  Significant outsourcing can
create poor labor relations with the remaining employees and may
encourage highly valuable employees to leave.  Quality may be more
difficult to control.  Perhaps most importantly, you have to consider
what your firm's core competency and source of competitive advantage
is.  It is rarely a good idea to outsource critical functions of a
firm, no matter how much the cost advantage to be obtained, because
valuable knowledge can be lost and further innovation in that area is
no longer a capability of your firm nor its exclusive property.  Once
a function is outsourced, you are guaranteed that your firm cannot do
it any better than its competitors because they can acquire the same
capability to outsourcing.  For many functions, this may not matter
and getting it at the lowest cost is the best way to be competitive in
that area.  However, in other cases, outsourcing a function can result
in a long-term loss of competitiveness.  While these factors are
difficult to reduce to a cash basis, they are important strategic
considerations when contemplating outsourcing.

Sincerely,

Wonko

if you are basing your decisions on cash flow then, it is neccesary
that the effect of tax be considered for both the labor costs as well
as the outsourcing costs. for eg. the labor costs are 100, the
outsourcing costs are 80, tax rate is 30%. the effective savings are

1) cost of labor:      100-30=70
2) cost of Outsourcing: 80-24=56
3)  total savings             14

if tax is not considered, the result would be 100-80=20. 

hence it is better to consider the tax rate.