A fundamental tenet of good business practice is to keep a lid on excessive costs and generally make sure that you are staying within your budget. Cost control is prudent. However, there is a distinction between cost savings and cost avoidance, and it is crucial for procurement teams, the finance division, and all business managers to be aware of this distinction.
When a basketball team knows they are going to lose a game, they still start their star player in the fourth quarter. Because the coach chose to keep the player on the court, the gap could be reduced from 25 points to just 10 points. However, compared to what it would have been had the star player been benched, the loss is not as significant. The equivalent in a procurement context would be if a supplier wanted to raise prices by 25% but the CPO was able to negotiate a 10% increase instead.
Identifying cost avoidance strategies on traditional balance sheets can be difficult, and they might even require a larger initial investment, but they can be very effective. In actuality, cost avoidance measures only have an impact on the balance sheet when they are not implemented because doing nothing has led to an increase in costs.
However, cost savings are the most important metric for most procurement teams because they are relatively simple to identify. They will show up as a decrease in spending on the budget and in the financial statements. In other words, it represents a decrease from the amount spent on the same item the previous year. To calculate cost savings in simple cash terms, subtract the new price from the original price.
Costs Savings vs Cost Avoidance
What is cost savings?
Cost-cutting measures that reduce current spending or debt levels are called expense mitigation strategies. Cost savings are usually tangible and measurable. Since cost-saving measures have an impact on already-existing line items, they will be reflected in documents like your budget and financial statements when comparing one accounting period to the next. Because they are measurable and documented, these kinds of strategies are typically simpler to use when justifying new projects and initiatives.
What is cost avoidance?
Cost avoidance, which is distinct from cost savings, refers to methods that stop a company or organization from in the future spending money that is not necessary. Since the cost savings achieved through cost avoidance are frequently fictitious, they rarely show up in financial statements or budgetary documents. If you try to reduce costs, but it doesn’t work, it might show up on your financial statements as an extra expense that you couldn’t avoid.
By proactively addressing the need for future purchases, you can lessen potential financial pitfalls and difficulties. However, because the costs avoided are typically fictitious and uncertain, it can be difficult to use cost avoidance to support an organization’s projects and initiatives.
Cost avoidance vs. cost savings
Although they have similar goals for a company or organization, cost avoidance and cost savings differ in several crucial ways. Here are some differences between cost avoidance and cost savings:
Here are some characteristics of cost avoidance:
Here are some characteristics of cost savings:
Examples of cost avoidance
Here are some examples of cost avoidance tactics to help you better understand the distinction between cost avoidance and cost savings:
A small business owner buys candlesticks from a specific vendor. The store owner has observed that the general market value of candle holders is rising, despite the fact that their wholesale cost has been stable over the past few years. The shop owner proactively negotiates a stable price contract for the following few years in order to prevent a future cost increase. The shop owner is utilizing a cost avoidance tactic by avoiding a potential future cost increase.
A manufacturer buys new machinery that needs to be shut down and serviced every two weeks. They discover a period of a few hours at night, every two weeks, when almost no units are produced after studying the company’s production schedule. The company schedules maintenance for these hours rather than shutting down when demand is high because this is already a slow period in their manufacturing flow. They are anticipating and avoiding future expenses, so this is an example of cost avoidance.
A restaurant decides to update their menu and add a dinner option that is a seasonal seafood entree. They are aware that past variations in weather have caused one specific ingredient’s price and availability to fluctuate. They obtain that ingredient from a number of suppliers in various locations in order to prepare for potential supply chain disruptions. They engage in cost avoidance by using a variety of suppliers to mitigate potential cost increases.
Examples of cost savings
Here are some examples of cost-saving tactics to help you better understand the distinction between cost avoidance and cost savings:
A construction company has provided concrete work for many years. Recent market conditions and increased demand have caused their cement price to rise. A company representative bargains with the supplier for a lower price in exchange for a long-term business relationship. Because it reduces a current, confirmed business expense, this is an illustration of a cost-saving measure.
A local bakery decides to use their increased profitability to redistribute some of their debts because their sales are strong. They are able to reduce the terms of the mortgage on their building to a lower interest rate based on their most recent account ledgers, which lowers their monthly payment and total amount due. By lowering a known, measurable current cost, they are exercising cost savings.
Traditionally, retail bookstore employees have been given the option to work as much overtime as they please. The company decides they need to find a way to practice cost savings in order to increase profitability as a result of market pressures and internal changes. The business decides to limit overtime for its employees unless they receive advance approval from a manager in order to reduce costs. This reduces their known labor costs and saves them money.
What are examples of cost avoidance?
Cost avoidance is the practice of maintaining current spending in order to avoid price increases brought on by economic factors, inflation, or rising costs for goods and services. When a business purchases an extended equipment warranty to reduce maintenance costs or out-of-pocket expenses, that is an example of cost avoidance.
What are avoided cost savings?
Definition: “Soft” cost savings/avoidance refers to measures taken to mitigate price increases in order to reduce future costs for a business. Process improvements that positively impact efficiency, productivity, customer satisfaction, etc. ; over time, the cost avoidance becomes cost savings.
How is cost avoidance savings calculated?
When a business lowers an existing expense, it can save money. For instance, replacing incandescent bulbs with LEDs can lower monthly electricity costs. Contrarily, an avoided cost is one that is not incurred. For instance, investing in cybersecurity can reduce the financial impact of a data breach.