Cost Avoidance Vs Cost Reduction: What’s The Difference?
When it comes to business, cutting any costs and avoiding any unnecessary expenditures is obviously key to improving profitability. Your profits will be higher if you can maintain a higher level of revenue and cash flow. Employees are often required by their employers to classify the financial benefits of capital investments or organisational initiatives as cost reduction or cost avoidance measures. This classification is often a grey area for non-financial employees. You should understand the difference between the two concepts as well as how the information on the financial statements may be reported if you have project management responsibilities or approval responsibilities for significant capital or program expenditures.
Direct Vs Indirect Costs
Before working out the difference between cost avoidance and cost reduction you must first understand the difference between direct and indirect costs and how these effect the savings. These are sometimes know as hard and soft costs.
Direct Costs (Hard Costs)
Direct spend is everything that goes into making a product. Direct spend is anything that has some kind of intrinsic value, usually a tangible asset. Direct costs are items like inventory, equipment, facilities, and land. For example, in construction, the materials needed to build a house would be considered direct costs
Indirect Costs (Soft Costs)
Intangible costs are usually associated with indirect costs. These usually cover professional services such as legal costs or accounting. It’s more difficult to quantify since you can’t predict them. Keeping a project on track until the end may mean growing indirect costs.
Cost avoidance measures and capacity enhancements are indicators of them. An example within construction would be any fees that a house builder would need to pay to an estate agent to sell the house they built. These are not considered direct costs (costs that went into building the physical building/house)
What is Cost Avoidance?
Cost avoidance is when you avoid incurring future costs. When it comes to business, the cost avoidance is a way to decrease future costs by lowering the potential for increased expenses.
The goal of cost avoidance is to reduce future costs.
As an example, you may need to change the tyres on your vehicle which can be costly. You can choose a premium brand or an economical brand. If the economical brand is 25% cheaper however only lasts half the time of the premium brand then that would increase future costs as you would need to replace them sooner. Whereas if you went for the premium brand you would pay 25% more for a product that lasts twice as long.
To put it another way, cost avoidance is a set of pre-emptive actions that prevent any future price increases. Cost avoidance doesn’t show up in a company’s financials or budget.
Although cost avoidance may incur temporary additional costs at first, these extra costs come from lowering a company’s future costs.
Another example could be the need for a company to digitalise their procurement processes. To do this they may need to invest in a procurement software to track their procurement savings. The company would need to look at the long term financial benefits of this system whilst comparing their current financial situation.
Say a procurement savings management platform costs the company $1,000 per year in licence costs, that would be considered temporary additional costs. The preventive future price increases, or cost avoidance can then be measured on the time saved by using the software (hours saved by collecting this data from different areas of the organisation or hours saved inputting the data into an Excel spreadsheet).
The main points to remember about Cost Avoidance are:
- Cost avoidance eliminates future expenses by anticipating and planning ahead.
- Expect to invest additional costs (see examples above) in order to obtain a larger future cost avoidance
- It can be challenging to assign a specific dollar amount to cost avoidance, since it deals with hypothetical future costs.
An avoidable cost is an expense that will not be incurred if a particular activity is not performed. Avoidable costs refer primarily to variable costs that can be removed from a business operation, unlike most fixed costs, which must be paid regardless of the activity level of a company. There are instances in which fixed costs can be avoidable costs. – Investopedia
What is Cost Reduction?
Cost reduction is achieved by reducing existing debt or spending, cost reduction strategies reduce existing expenses. Cost reduction savings are usually tangible and measurable.
In contrast to cost avoidance, cost reduction is reflected in a company’s budget and financial statements. The term “direct savings” refers to savings achieved through actions such as reducing debt, spending, or investing, all of which is achieved through cost reduction rather than avoidance.
Any measure that produces measurable financial benefits for the company is considered a cost reduction measure.
An example: A supplier contract is about to expire and a company achieves better commercial rates when renewing or switching to a different supplier. A reduction is price or cost reduction has been achieved.
Cost cutting refers to measures implemented by a company to reduce its expenses and improve profitability. Cost cutting measures are typically implemented during times of financial distress for a company or during economic downturns. They can also be enacted if a company’s management expects profitability issues in the future, where cost cutting can then become part of the business strategy. – Investopedia
Examples of Cost Reductions
Price Negotiation
Budgets can be significantly impacted by the procurement department. It may be possible to negotiate with the vendor to get a lower price per unit if you’ve been buying a fixed amount and need to increase your volume. Budget for next year any cost savings that the procurement department achieves with a new price.
Contract Management
A contract negotiation, whether it’s an initial contract or a renewal, offers the potential for cost savings. Procurement staff can negotiate the best deal with potential vendors, whether it is through a reduced overall price for a longer contract or value-added services. By locking in a discount for several years, a contract can help you reduce your costs in the long run. Contract Management software can also help avoid common mistakes such as automatic contract rollovers which can be costly.
Supplier Management
Keeping your procurement costs low begins with choosing the right supplier. Suppliers with the right products and materials will almost always be able to deliver them at the right time and at the right price.
If you choose the wrong supplier, however, you may end up working with a company that is both unreliable and expensive – threatening both your bottom line and reputation with clients and customers.
Working with compliant suppliers and managing the risks help companies save on costly mistakes.
Having a good relationship with your suppliers can also show huge financial benefits when it comes to contract renewals and price negotiation. A supplier management software for procurement departments can held manage and strengthen supplier relationships.
How To Measure Cost Savings?
Savings cannot be measured by a simple formula. Moreover, procurement is not a completely independent process; it depends to some extent on other disciplines. Savings are therefore difficult to measure.
A reduction in cost is always viewed negatively in comparison to the new negotiated price. Without prior cost references, cost savings could be calculated from the first offer received or based on market benchmarks.
What is the best way to calculate cost savings in procurement? The average price of all quotes received is subtracted from the negotiated contract price. The actual number of items bought during the period of calculation is multiplied by this value.
For example:
Average price quoted for ‘Product A’ = $10
Final negotiated price for ‘Product A’ = $8
Total saving per unit of ‘Product A’ = $2 (then multiple this by the total quantity you need)
Definitions
- Cost Savings: comparing the results of current and prior year cost-saving initiatives.
- Cost Reduction: An impact on the balance sheet resulting from the levels before and after sourcing is referred to as capital reduction.
- Cost Avoidance: During the procurement life cycle, avoidance: avoiding price increases wherever possible.
- Addressable Spend: Includes expenditures that produce benefits.
- Total Procurement Benefits: is the total value created by purchasing. Cost savings, capital savings, and avoidance are added together to calculate the result.
Additional Resources
These external articles contain useful points to consider: