Deliver Credibility, Accuracy, Practical Value
Building the Business Case
Solution Matrix Ltd®

Avoided Cost, Cost Savings, and Opportunity Cost
Definitions, Meaning Explained, and Example Calculations

 

A routine oil change is a familiar example of cost avoidance. Small investments in preventative maintenance helps avoid the much larger cost of replacing an engine later.

Cost savings, avoided cost, and opportunity cost must be understood as relative terms. They have meaning only when comparing one outcome to another.

What are Avoided Costs, Cost Savings, and Opportunity Costs?

The three terms cost savings, avoided cost, and opportunity cost can play an important role in business planning, budgeting and decision support.

Whereas most business people readily accept cost savings as a legitimate concept, the terms avoided cost and opportunity costs can be more problematic for some. Some businesspeople—including some financial specialists—do grant the same legitimacy to the latter two concepts. That is unfortunate because all of these terms carry useful information for business analysis and decision support—for those who understand them and use them properly.

One reason for the confusion sometimes surrounding these cost concepts is that all three terms are relative terms. They have reality only when comparing one business outcome to another. Their magnitudes represent differences between outcomes, not absolute values. Very briefly the three cost concepts are defined as follows:  

Cost Savings

Cost savings refers to an expense already incurred, or a cost already being paid. If a driver trades the current vehicle for a more fuel efficient vehicle, while maintaining the same driving habits, the driver can expect a cost savings in fuel costs.

Avoided Cost

An avoided cost is also a cost savings, but the reference is to a cost (expense) not yet incurred. Preventative maintenance for the vehicle—such as regular oil changes—avoids the future cost of replacing an engine. The avoided cost is very real because the future cost is certainly coming if the driver omits maintenance.

Opportunity Cost

Opportunity cost refers to a foregone gain that follows from choosing one outcome over another. By contrast, the gain certainly would have appeared had the decision maker chosen a different action and outcome.

Suppose for instance, a collector of classic automobiles offers a very large sum to purchase the driver's car. The driver must choose between two incompatible actions and their outcomes:

  • Firstly, continue owning and driving the car.
  • Secondly, selling the car to the collector.

The driver may see many benefits in choosing the first option, turning down the offer, but that option also brings a very large and real opportunity cost.

For those who can accept that foregoing an otherwise definite gain equates to paying a certain kind of cost, the term opportunity cost has meaning.

Explaining Relative Cost Terms in Context, With Examples

Sections below further define and explain the relative costing terms cost savings, avoided cost, and opportunity cost. Building an accurate understanding of these terms is easier in the context of numerical examples. Examples below illustrate the role of these terms in business decision support and business case analysis.


 

Contents

Related Topics


 

All Are Relative Terms: Cost Savings, Avoided Cost, Opportunity Cost

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.

Defining and Calculating Cost Savings
But How Long is Life?

Most people readily accept cost savings as a legitimate benefit in the business case, when they propose action that 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.

We must be able to show in credible terms, of course, that lower costs in the future are certain. For this, the analyst estimates kilowatt hour power consumption as it is now, and then as it will be after changing bulbs. The analyst must also make assumptions about light usage under the new plan, and consider all the costs of making the switch. Any of those assumptions might be open for debate or challenge. Assumptions aside, however, almost everyone accepts the cost savings concept as legitimate and acceptable. No one doubts that the savings are real and measurable. As a result, they can move forward, confidently, and reduce this item's claim in next year's operating budget.

Many people are less comfortable, however, when avoided costs and opportunity costs enter the picture. The rationale that legitimizes these cost concepts is in fact nearly identical to the reasoning behind ordinary cost savings. Legitimacy for these latter concepts, however, requires a few additional assumptions as the following sections show.

Cost Questions That Call for a Business Case

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, absent any other actions, management will soon have to hire more call center agents to handle the volume. "Business as usual," in other words, means hiring more staff—an expensive proposition.

In fact, however, management determines that another solution for the call volume problem just may be possible. This includes advanced training for the current staff and the purchase of more efficient call center equipment. Management must now address this question: Which is the better business decision: Choosing Business as Usual, or choosing the Training and Equipment option?

To find an answer, management commissions a business case analysis to project the likely business outcomes under three different scenarios.

Scenario 1: Business as Usual

If the firm were to choose this scenario for implementation, it would simply hire an extra call center agent in Year 1, and another additional agent in Year 2 in order to meet call volume needs. It is easy to forecast the costs and gains from doing so:

  • First and second year salaries costs will be $500,000 and $600,000, respectively.
  • Gross profits should be $1,760,000 in Year 1 and $2,200,000 in Year 2.

The business case analyst builds this scenario, incidentally, even when the firm is certain not to choose " Business as Usual." The Business as Usual Scenario is necessary as a baseline for measuring changes under other scenarios. In this way, cost and benefit estimates for Business as Usual are the basis for calculating cost savings, avoided costs, and opportunity costs they expect with different solutions.

Scenario 2: Training and Equipment

Internal consultants advise meeting the growing call volume needs with two specific actions:

  • Firstly, train current staff in more efficient and effective call handling.
  • Secondly, provide current staff with better information access equipment and better call support software.

These two actions taken together represent business case Scenario 2, Training and Costs and benefits that follow under Scenario 2 are also easy to estimate.

  • First and second year salaries costs will be $400,000 and $420,000, respectively.
  • First and second year training and equipment costs will be 50,000 each year.
  • Gross profits should be $1,760,000 in Year 1 and $2,200,000 in Year 2.

Note especially that Scenarios 1 and 2 both brings new costs, but each solves the call volume problem. Either way, the firm meets customer needs and, and as a result, the firm looks forward to the same gross profits each year.

Management, however, is also considering another possible use of the same funds. 

Scenario 3: CD Investment

The CFO has turned up another investment possibility. A certificate of deposit (CD) paying a very attractive 10% interest per year is available to the firm, as well. Note especially that under Scenario 3, call center service degrades and, as a result, projected gross profits are less than the Scenario 1 and 2 projections. The business case analysis should show whether or not the large return on investment from the CD purchase offsets the slightly lower profits under the other scenarios. For Scenario 3, the firm projects:

  • First and second year CD purchase costs of $100,000..
  • First and second year salaries costs will be $400,000 and $420,000, respectively.
  • Gross profits should be $1,600,000 in Year 1 and $2,000,000 in Year 2.

The Better Business Decision

Exhibit 1 below shows the cash flow estimates that summarize projected cost and benefit projections for each scenario. Which scenario represents the better business decision? For an answer, the firm turns to business case results that include net gains, cost savings, avoided costs, and opportunity costs.

Proposals Competing For Funding
Consider the Costs

 

Exhibit 1. The figure shows cash flow summaries for a three-scenario business case. The upper three panels hold full value cash flow estimates for the three scenarios. The lower two panels are incremental cash flow summaries, comparing the two Proposal scenarios to Business as Usual.

In this case, the firm does not have sufficient working capital to implement both Scenarios 2 and 3 at the same time. As a result, the two proposal scenarios are competing for funding because the firm can implement only one of them.

The business case analyst attempts to compare the three scenarios fairly, by projecting cash inflows and outflows under each. Note especially that all three cash flow scenarios in Exhibit 1 have exactly the same cash inflow and outflow line items: that is what makes the comparison fair.

In order to bring out the avoided costs and opportunity costs, however, the analyst must also 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.

Two panels at the bottom of Exhibit 1 summarize the incremental cash flow estimates. Sections below discuss the cost savings, avoided costs, and opportunity costs that emerge from the incremental statements.

What is an Avoided Cost?
Definition, Meaning, Calculation

When an action prevents a future cost, the result is cost avoidance—if it is reasonably certain that the cost would appear absent the action.

Preventative maintenance for machinery, for instance, is rightly called cost avoidance. Regular oil changes for an automobile, for example, prevent the need for rebuilding or replacing the engine. Without preventative maintenance, the owner would certainly 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 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 underway. With an avoided cost, by contrast, 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 certainly come without the proposal action.

What is Opportunity Cost?
Definition, Meaning, and Calculation

Business analysts normally define opportunity cost as foregoing a gain that would otherwise 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.

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.

For a complete tutorial and examples on building financial models of the kind shown above, see Financial Modeling Pro.