Avoided Cost, Cost Savings, and Opportunity Cost Explained
Definitions, Meaning, and Example Calculations
Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-09-18.
Cost savings, opportunity cost, and avoided cost are relative terms, These terms have meaning and value only when one decision option (or scenario) is compared to another.
The terms cost savings, avoided cost, and opportunity cost can play an important role in business planning and decision support. Whereas most business people readily accept the idea of cost savings as a legitimate concept, however, the terms avoided cost and opportunity costs can be more problematic for some. That is unfortunate because all of these terms carry useful information for business analysis and decision support when understood and used properly.
This entry defines and explains the terms cost savings, opportunity costs and avoided costs, illustrated in the context of an example case.
• Cost savings, avoided costs, and opportunity costs are relative terms.
• The meaning of cost savings
• Cost savings, avoided cost, opportunity cost explained with examples
• The meaning of avoided costs
• The meaning of opportunity costs
Cost savings, avoided costs, and opportunity costs are relative terms.
The concepts cost savings, avoided costs, and opportunity costs are all based on similar reasoning. These are relative terms that have meaning only when one outcome is compared to another. When any of these terms appears in business planning or decision support, the key questions are:
- Which courses of action are really possible?
- What are the outcomes under each option?
Consider first the simpler and less controversial term, cost savings.
The meaning of cost savings
Most people readily accept cost savings as a legitimate benefit in the business case, when a proposed action will clearly reduce costs. If, for instance, we plan to lower the electric bill for office lighting by switching to energy saving fluorescent bulbs, no one rejects the legitimacy of the cost savings benefit for the plan.
Of course the analyst has to estimate kilowatt hour consumption as it is and as it will be, make assumptions about light usage under the new plan, and consider all the costs of switching. Any of those points might be debated or challenged, but the idea of cost savings itself is acceptable and legitimate. No one doubts that the savings are real and measurable, and next year's operating budget may be adjusted downward based on this belief.
Many people are less comfortable, however, when avoided costs and opportunity costs enter the picture. The rationale legitimizing these costs is similar to the reasoning behind cost savings, but they cannot be granted legitimacy automatically until a few additional assumptions are made, as shown below.
Avoided cost and opportunity cost explained with examples
Consider a company that has a customer service call center, where call volume is increasing rapidly. This means that call center agents are "at capacity" and, without a better solution, management will soon have to hire more call center agents to handle the volume. "Business as usual," in other words, means hiring more staff. In fact, however, management determines that two different solutions for the call volume problem are possible:
- Business as Usual Scenario: Hire an extra call center agent in Year 1, and another additional agent in Year 2, in order to meet call volume needs.
- Training and Equipment Scenario: Train current call center staff in more efficient call handling and provide them with better information access and call support software.
Either solution brings new costs, but each solves the call volume problem. Either way, customer satisfaction needs are met, and as a result, annual growth in gross profits is projected at a 10% rate. Management, however, is also considering another possible use of the same funds.
- CD Investment Scenario: a certificate of deposit (CD) paying a very attractive 10% interest per year is available as well. Under this scenario, however call center service degrades and projected gross profits growth is less.
Business as usual and the two proposal scenarios are competing for funding and only one will be implemented. The business case analyst attempts to compare the three scenarios fairly, by projecting cash inflows and outflows under each. Notice that the three cash flow scenarios at left have exactly the same cash inflow and outflow line items: that is what makes the comparison fair. For a complete introduction to business case scenario building, see Business Case Essentials.
In order to bring out the avoided costs and opportunity costs, however, the analyst also has to produce incremental cash flow summaries for the two proposal scenarios. (Incremental cash flow is the difference between the proposal scenario value and the corresponding Business as usual cash flow.)
The meaning of avoided cost
When an action prevents a future cost, the result is called an avoided cost—if it is reasonably certain that the cost would have appeared without the action.
Preventative maintenance for machinery, for instance, can be thought of as the practice of avoiding costs, or cost avoidance. Regular oil changes for an automobile, for example, prevent or delay the need for a costly engine rebuild or replacement that would certainly come without the oil changes.
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 extra hiring was truly coming under Business as Usual. Mathematically, an avoided cost appears in comparisons exactly the same way that cost savings appear. The difference is that under cost savings, the scenario looks forward to reducing spending already taking place, while with an avoided cost, the increase has not yet occurred. The legitimacy of the avoided costs depends on the analyst's ability to show that the increase will certainly come without the proposed action.
The meaning of opportunity cost
Opportunity cost is normally defined as foregoing a gain that would appear by choosing a different course of action. There are several opportunity costs in this example, as well, but the definition in each case depends on which comparison is in view.
If the "Training and Equipment" proposal or the Business as Usual scenario is chosen, then the potential interest earnings from the CD investment are an opportunity cost, relative to those options.
If the CD purchase proposal is implemented, then the gross profit increase is an opportunity cost, relative to Training and Equipment and also relative to Business as usual, as shown on the CD investment incremental scenario. For a complete tutorial and examples on building financial models of the kind shown above, see Financial Modeling Pro.
Opportunity cost is not so-labeled on the cash flow summaries above, but it is seen by finding an expected gain on one scenario that is absent on another.
Avoided costs and opportunity costs, in other words, can be real, measurable, and legitimate topics for discussion. Whether or not they are important and how they should contribute to the decisions, can only be seen when all the important consequences of each choice are in view.
By Marty Schmidt. Copyright © 2004-.