COST AVOIDANCE REVIEW OF RELATED LITERATURE

In 2006, CAPS released a critical issues report entitled “Defining Cost Reduction and

Avoidance.” In this report, they note seven major points that really need to be stressed:

 Critical to the sourcing professional’s mission of reducing costs and delivering savings is

the proper categorization of the various types of cost reduction and their application to the

company’s operating budgets and profit and loss measures;

 Cost reductions come in two different categories: “hard” cost savings and “soft” cost

avoidance;

 A great deal of supply management’s efforts results in cost avoidance, yet this category

is more intangible than cost savings;

 Even though many people might find it easy to discount cost avoidance as “phantom” or

lesser savings to the company, these are “real” savings nonetheless and, despite the

challenge, these savings must be properly quantified;

 Flexible and comprehensive IT systems are crucial, as they are the medium that will

provide the visibility needed to accurately assess costs and expenditures;

 Metrics to track cost savings and cost avoidance should be standardized throughout the

company, should be clearly defined, and should be available to all personnel; and

 The key to success is to create a proper incentive structure for supply management

personnel. (Lamoureux, n.d.)

Cost avoidance refers to reductions that cause future spending to fall, but not below the level

of current spending. Often. Cost avoidance involves slowing the rate of cost increases. (Schaffer,

2015) According to Lianabel Oliver (2016), these measures are any actions that avoid having to

incur costs in the future. They represent potential increases in costs that are averted through

specific preemptive actions. These measures will never be reflected in the budget or the financial
statements. Thus, they will only be reflected in situations where the proposed action is not

implemented, resulting in a cost increase. When an action prevents a future cost, the result is

cost avoidance—if and only if it is reasonably sure that the charge will arrive, absent the action.

(Schmidt, 2018)

This accounts for the situations where spend[ing] is higher due to higher demand but overall

cost per unit is lower, where up-front investments reduce overall spend[ing] in one or more

categories over a multi-year initiative, and where a process improvement or product replacement

resulted in a lower operating cost or cost per unit compared to what the company would have

spent had the company not improved the process or replaces the product. (Lamoureux, n.d.)

Cost avoidance creates important strategic value for an organization, per the following:

 Strategic procurement behavior, relating to purchasing products with improved quality

and/or effectiveness to improve business operations, is often ignored in savings

calculations.

 Procurement is often tasked with driving greater compliance, oversight and transparency

when sourcing, thereby mitigating many risk-associated costs.

 Cost avoidance typically targets areas of strategic spend, which tend to be new

investments, capabilities, or technologies with no previously comparable purchase. (Yin,

2017)

Mark O’Connell (2017), in his article “Savings vs Cost Avoidance— What’s the Difference?”

presented a process that can measure the cost avoidance of a company. The process is

enumerated below.

1. Get the “savings vs avoidance” rules reviewed and approved by your accounting team.

2. Create a ticketing scheme or database to record all claims of operating expenses

reductions.
 3. Assign operating expenses reduction targets to individuals appropriately.

4. Require the author of each claimed reduction to defend it according to the rules.

5. Assign someone the duty of reviewing and approving all such claims.

6. Tally approved operating expenses reduction claims to compare them with the targets.

On the other hand, David S. Yin (2017) pointed out five ways to deliver cost avoidance which

are listed below.

1. Price protection. Delaying price increases, or slowing the rate of price increases with

price protection. For example, if forecasts for the pulp and paper index are projected to

increase, include provisions in the contract when sourcing corrugated boxes to mitigate

rising prices.

2. Negotiation. Negotiating prices that are lower that initial quotes. This is usually employed

for one-off capital expenditures (e.g., construction projects, technological investments) as

opposed to recurring operational expenditures.

3. Value-add. Including additional value-added goods and services free-of-charge to an

agreement. For example, when bidding on a large piece of industrial equipment, the

supplier can also include installation and maintenance services free-of-charge.

4. Continuous improvement savings. Signing long-term contracts with continuous

improvement savings requirements. These are often provisions in contracts that require

the supplier to create ways to reduce the buyer’s total cost of use through standardization,

labor reduction, etc.

5. Substitutes. Identifying substitutes that perform the same or similar functions at lower

cost, or those that are the same cost with greater quality/efficiency. For example, replacing

previously-used electrical components for those that have greater energy efficiency and

thus save on energy costs.

Regular oil changes for an automobile, for example, prevent the need for rebuilding or replacing

the engine. Without preventative maintenance, the owner will undoubtedly face these costs.

Both incremental scenarios in the example show an avoided cost for hiring and salaries. This

cost avoidance is legitimately called an avoided cost, and a cash inflow on the incremental

summary, if and only if the new employees were coming under Business as Usual.

Mathematically, an avoided cost appears in these comparisons in precisely the same way that

cost savings appear. The difference is that cost savings, the scenario looks forward to reducing

spending already underway. With an avoided cost, by contrast, the cost increase is in the future.

As a result, the “bottom line” on avoided costs has to do with an assumption:

The legitimacy of the avoided costs depends on the analyst’s ability to assume, and show

convincingly that the increase will undoubtedly come, absent the proposed action.

(Schmidt, 2018)
Bibliography
Lamoureux, M. (n.d.). Cost Reduction and Avoidance: Best Practice Principles of Corporate Procurement.
Retrieved from eSourcing Wiki:
www.esourcingwiki.com/index.php/Cost_Reduction_and_Avoidance

O'Connell, M. (2017, May 3). Savings vs Cost Avoidance: What's the Difference? Retrieved from
siwel.com: www.siwel.com/blog/savings-vs-cost-avoidance-whats-the-difference

Oliver, L. (2016, August 31). Cost Savings and Cost Avoidance: Why You Should Know the Difference.
Retrieved from medium.com: medium.com/@lianabeloliver/cost-savings-and-cost-avoidance-
why-you-should-know-the-difference-2eb627965067

Schaffer, J. (2015, July 21). How to Calculate Cost Savings. Retrieved from cellaconsulting.com:
www.cellaconsulting.com/blog/calculate-cost-savings/

Schmidt, M. (2018, September 11). Avoided Cost, Cost Savings, and Opportunity Cost: Definitions,
Meaning Explained, and Example Calculations. Retrieved from business-case-analysis.com:
www.business-case-analysis.com/avoided-cost.html#pagetop

Yin, D. S. (2017, February 15). Five Ways to Drive Value through Cost Avoidance in Procurement.
Retrieved from mypurchasingcenter.com:
www.mypurchasingcenter.com/technology/technology-blogs/five-ways-drive-value-through-
cost-avoidance-procurement/