Opportunity Cost, Avoided Cost. Are They Real?

Captain’s Log, Entry 7924.4Avoided costs and opportunity costs can all play an important role in business planning, budgeting and decision support. Nevertheless, some financial specialists do not grant these costs legitimacy for the business case. Is this exclusion justified? 

I spoke recently with a project manager whose project funding proposal had just failed.

The Project Management Office—and the company CFO in particular—turned thumbs down on the manager’s Stage-0 business case. Why? Where was the red flag? Avoided costs!

Learn how to calculate and present relative costs in the online article: Cost savings, Avoiding Costs, and Opportunity costs

The CFO Wades In … With an Objection

The manager’s case came with attractive profitability (ROI) and minimal risks for the proposed project.  In the CFO’s view, however, there was just one problem: the manager showed how to avoid costs. Profitability and other business benefits depended heavily on projected avoided costsFor this CFO, cost avoidance simply was not a legitimate business case benefit. The project manager was trying to decide whether to abandon the business case, or to challenge the CFO’s reasoning and appeal the decision.

In fact, avoided costs, opportunity costs, and cost savings can all play an important role in business planning, budgeting, and decision support.

Most business people readily accept cost savings as a legitimate concept. However, the terms avoided cost, and opportunity cost can be a problem for some. That is unfortunate because all three terms carry useful information for business analysis and decision support.

One reason for the confusion sometimes surrounding these cost concepts is that all three are relative terms. They have the reality, that when you measure one scenario business outcome and compare it to outcomes under another scenario.

Very briefly, these terms mean the following:

Cost Savings

Cost savings refers to a cost (expense) for which payments are already underway. If a driver trades the current vehicle for a more efficient vehicle, while keeping the same driving habits, the driver can expect savings in fuel costs.

Avoided Cost

Avoiding a cost is also a real cost-saving, but it refers to an expense for which payments are not yet underway. Preventative maintenance for the vehicle (e.g., regular oil changes) avoids the future cost of replacing an engine. Without the oil changes, the engine cost is certainly coming. This certainty—absent oil changes—legitimizes the avoided cost.

Opportunity Cost

Opportunity cost refers to a foregone gain that follows from choosing one action instead of another. 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 outcomes:

  1. Continuing owning and driving the car.
  2. Selling the car to the collector.

The driver may see many other gains under option 1 (turning down the offer), but option 1 also brings a very large and real opportunity cost.

Legitimate Cost for the Business Case?

In brief, all three cost concepts can have meaning in the business case. However, legitimacy results only when everyone understands the unique relative nature of each concept. These costs exist only when comparing one business case scenario to another.

Learn how to calculate and present relative costs in “Cost savings, Avoided Costs, and Opportunity Costs”

Take Action!

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Author: Marty Schmidt

Marty Schmidt is Founder and President of Solution Matrix Limited, a Boston-based firm specializing in Business Case Analysis. Dr. Schmidt leads the firm's Management Consulting, Publishing, and Professional Training activities. He holds the M.B.A degree from Babson College and a Ph.D. from Purdue University.