The three terms "cost savings," "avoided cost," and "opportunity cost" can play an essential 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 correctly.
One reason for the confusion sometimes surrounding these cost concepts is that all three terms are relative terms. They only exist when comparing one business outcome to another. Their magnitudes represent differences between outcome values, not absolute values. Very briefly the three cost concepts are defined as follows:
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 car, while maintaining the same driving habits, the driver can expect a cost saving in fuel costs.
An avoided cost is also a cost saving, but the reference is to a charge 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 genuine because the replacement charge is undoubtedly coming if the driver omits maintenance.
Opportunity costrefers to a foregone gain that follows from choosing one outcome over another. The benefit indeed would have appeared if the decision maker had selected a different result.
Suppose, for instance, a collector of classic automobiles offers a substantial sum to purchase the driver's car. The driver must choose between two mutually exclusive 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 real opportunity cost.
For those who can accept that not choosing an otherwise likely gain equates to paying a particular kind of cost, the term opportunity costhas meaning.
Explaining Relative Cost Terms in Context, With Examples
Sections below further define and describe the relative costing terms cost savings, avoided cost, and opportunity cost. Building an accurate understanding of these terms is more natural in the context of numerical examples. Examples below illustrate the role of these terms in business decision support and business case analysis.
- What are "avoided costs," "cost savings," and "opportunity cost?"
- "Cost saving," "avoided cost," and "opportunity cost" are relative terms.
- Defining and calculating cost savings.
- Cost questions call for a business case.
- How do cost proposals compete for funding?
- Avoided cost: Meaning and calculation.
- Opportunity cost: Meaning and calculation.
- The articles Cost Object and Expense explain the precise meaning of those terms in accounting.
- For more on the role of relative cost terms in decision support, see Business Case.
- For more in-depth examples illustrating cost savings, avoided costs and opportunity costs in business case analysis, see the PDF ebooks Business Case Essentials and Business Case Guide.
The concepts "cost saving," "avoided cost," and "opportunity cost" are all based on similar reasoning. These are relative terms that have meaning only when the analyst compares one outcome to anotherWhen any of these terms appears in business planning or decision support, the fundamental questions are:
- Which courses of action are realistically possible?
- What are the outcomes under each option?
Consider first in the next section, the familiar and less controversial term "cost savings."
Most people readily accept cost savings as a legitimate benefit in the business case, when they propose action that will 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 credibly, 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 uncomfortable, 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.
Consider a company that has a customer service call center, where call volume is increasing rapidly. In this case, call center agents are "at capacity." Absent any other actions the company 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 may be possible. This alternative solution involves 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 hire an extra call center agent in Year 1, and another additional agent in Year 2 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 not likely 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 the "Business as Usual" scenario, provide a means of calculating "cost savings," "avoided costs," and "opportunity costs" in the other scenarios.
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 salary 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 that Scenarios 1 and Scenario 2 both result in 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 desirable 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 Scenario 2 projections. The business case analysis should show whether or not the substantial 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.
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 Scenario 2 and Scenario 3 at the same time. As a result, the two proposal scenarios are competing for funding because the firm can execute only one of them.
The business case analyst attempts to compare the three scenarios fairly, by projecting cash inflows and outflows under each.Note that all three cash flow scenarios in Exhibit 1 have precisely the same cash inflow and outflow line items: that is what makes the comparison fair.
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.
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.
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 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 under 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.
Business analysts usually define opportunity cost as bypassing 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 firm chooses either the "Training and Equipment" proposal or the "Business as Usual" scenario, then the potential interest earnings from the CD investment are an opportunity cost, relative to those options.
If instead, the firm chooses the "CD purchase" proposal, 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. The analyst can know whether or not they are significant enough to matter in a particular case, only by comparing the likely outcomes in each scenario.
For a complete tutorial and examples on building financial models of the kind shown above, see Financial Modeling Pro.