Three nessential cost concepts are often center-stage when making spending decisions or plans that have financial consequences:
- Cost savings
- Avoided cost
- Opportunity cost
When everyone involved understands these terms and uses them properly, they communicate information essential for making informed decisions or choosing a course of action. Ignoring their presence can result in less-than-optimal—or regrettable—business decisions.
Legitimacy is a Problem for Some
Most businesspeople readily accept cost savings as a legitimate concept and a legitimate business benefit for financial cost-benefit studies. However, the ideas "avoided cost" and "opportunity cost" can be more problematic for some.
Some people—including a few financial specialists—do not automatically 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.
One reason for the confusion sometimes surrounding these cost concepts is none of these terms that all three terms are relative terms. They exist and have meaning only when comparing one business outcome to another. Their magnitudes represent differences between outcomes, not absolute values.
Define Your Terms!
For finance and business analysis purposes, define these cost concepts as follows:
In this way, an automobile owner who trades the current vehicle for a more fuel-efficient car, while maintaining the same driving habits, can expect a cost savings in for fuel.
Avoided cost is just a special form of cost savings, where the savings is relative to likely future spending rather than current or historical spending.
Preventative maintenance for a vehicle such as regular oil changes avoids the future cost of replacing an engine. The avoided cost is a legitimate (future) cost savings because the replacement charge is certainly coming if the owner omits maintenance.
Suppose a home owner has available $100,000 to spend. The owner must choose one of two possible options: (1) Investing $100,000 in home maintenance and upgrades, or (2) Purchase a certificate of deposit (CD) for $100,000, earning interest at an annual rate of 5%.
If the owner chooses option (1), upgrading the home, there will be no interest earned from the CD. The opportunity cost of option (1) is thus the foregone annual interest that would certainly appear if the decision maker selects the CD option instead.
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, emphasizing four themes:
- First, showing how the relative cost terms, Avoided Cost, Cost Savings, and Opportunity Cost can play a legitimate role in business analysis for budgeting, planning, and decision support.
- Second, showing how project Cost Savings by comparing forecast figures to base line figures.
- Third, showing that Avoided Costs are--mathematically--the same cost savings, but that avoided costs are legitimate only when the analyst proves that a cost will follow absent the proposed action.
- Fourth, showing how Opportunity cost has meaning as a foregone benefit, only when the analyst or investor must choose between different options.
- What are "avoided costs," "cost savings," and "opportunity cost?"
- Relativity: "Cost saving," "avoided cost," and "opportunity cost".
- Cost savings concept is readily acceptable.
- Example: Cost questions, business case answers.
- Avoided cost example.
- Opportunity cost example.
- 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 all involve similar reasoning. These are relative terms that have meaning only when the analyst compares one outcome to another. When 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?
- How do the outcomes under different actions compare to each other/
Consider first in the next section, the familiar and least controversial term: cost savings.
Most people readily accept cost savings as a legitimate "benefit" for cost-benefit studies or business case analyses, especially when they propose actions aiming to reduce costs. If, for instance, one plans to lower the electric bill for office lighting by switching to energy-saving LED bulbs, no one rejects the legitimacy of the cost savings benefit.
The analyst must be able to show credibly, of course, that lower costs in the future are certain. For the LED example, this requires
- Estimating kilowatt hour consumption as it is now, and then as it will be after changing bulbs.
- Making assumptions about current light usage and light usage under the new plan
- Considering all the costs of making the switch (e.g., for buying, installing, and disposing of light bulbs).
Any of those assumptions might be open for debate or challenge. If the assumptions hold, however, the forecast cost savings will be accepted as legitimate, real, and measurable. As a result, the firm 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, even though the rationale legitimizing these cost concepts is nearly similar to the rationale for cost savings. Following sections show that legitimacy for these latter concepts requires a few additional assumptions.
The case study below should help explain the special nature of avoided costs and opportunity costs—and the reasons these concepts are problematic for some.
As an example, consider a company that operates 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 rising call volume. "Business as usual," in other words, means hiring more staff—an expensive proposition.
Management determines, however, that another solution for the call volume issue may exist. This alternative solution involves more training for the current staff and purchasing more efficient call center equipment. Management must now address this question: Which is the better business decision:
- Choose Business as Usual (hire more staff to handle call volume)?
- Choose the Training and Equipment option (to improve efficiency of existing staff)?
- Or, choose another option?
To help find an answer, the firm commissions a business case to project to analysze and and compare the likely business outcomes under three different scenarios.
Note that Proposal Scenario 1 and Business as Usual Scenario 3 (below) both bring new costs, but each does solve the call volume problem. Either way, under Scenario 1 or Scenario 3, 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: Purchase a Certificate of Deposit Investment. That possibility is business case Proposal Scenario 2.
Finally, the analyst builds Scenario 3, Business as Usual. This represents one more possible course of action but it also serves as "baseline" that will be compared to each of the two Proposal scenarios. Baseline cash flow figures in Scenario 3 makes it possible to measure "What Changes and by how much" in case the firm implements either Scenario 1 or Scenario 2.
This Business as Usual Scenario forecasts cash flows for the same cost and benefit items as Scenarios 1 and 2, assuming that the firm does not implement either proposal scenario.
The business case analyst builds the Business as Usual scenario, incidentally, even when the firm is not likely not to choose "Business as Usual" for implementation. The Business as Usual Scenario in fact serves three purposes:
- First, inflow and outflow forecasts for this scenario show "What happens" if the firm does choose to take this course of action, that is, take no action aside from extra hiring, as planned, under business as usual.
- Secondly, cash flow figures in Scenario 3 provide the necessary baseline for measuring the magnitudes of changes to expect, should the firm implement either Proposal Scenrio 1 or Scenario 2.
- Thirdly, the Business as Usual inflow and outflow are necessary for revealing any "cost savings," "avoided costs," or "opportunity costs" present with the other scenarios.
Which Scenario Is the Better Business Decision?
This company will choose one of three possible scenarios for implementation. Note, incidentally, that this firm does not have sufficient funds available to implement both proposal scenarios at the same time. This means they can execute only one of these plans, and the two proposal scenarios are therefore competing for funding.
Aiming for Business Case Results
When the analyst projects the likely cash flow consequences under one or more scenarios, the analyst is creating forecasts. Forecasts address the question: "What happens if we take this or that action?" That is Business Case Results Step 1 in the following section.
When the analyst compares different proposal scenario forecasts directly with the Business as Usual forecast, the analyst is developing information necessary for making the case that one scenario is preferred over others. These comparisons address this question: "Specifically what changes if we implement a proposal scenario, and by how much? That is Business Case Results Step 2 in the section after next.
The analyst forecasts likely cash inflows and outflows for a designated set of cost and benefit items, across two or more future periods, under each scenario. In a commercial business, these forecasts would reflect the firm's cost structure, sales forecasts, market position, and business model, as well as any ongoing changes or trends in any of these factors.
Exhibit 1 summarizes these scenario forecasts for this example. The summary for each scenario is represents a full-value cash flow statement for the scenario.
Full-value cash flow statements (Exhibit 1 ) are a necessary step towards business case results but they are not the final step. They show expected cash flow outcomes for a few selected line items but they do not, by themselves directly address urgent questions such as these:
- Which scenario represents the better business decision?
- Where are cost savings, avoided costs, and opportunity costs in each scenario?
These questions call for direct scenario comparisons. Business Case
The terms better "better," "cost savings," "avoided cost," and "opportunity cost" are all relative terms, which have meaning only when comoparing one scenario directly with another. That is the role of Business Case Results Step 2, measuring Incremental Cash Flow.
The Incremental Cash Flow Concept
Incremental cash flow, as the name suggests, is simply the difference between the cash flow measure in one scenario and the same cash flow measure in another scenario. The standard approach in business case analysis defines incremental differences is the following:
The formula above is simple and easy to apply—as long as the analyst calculates with two simple rules in mind. These conventions reduce the risk of confusing inflows with outflows, or confusing addition with subtraction. Always…
- Write cash outflow as a negative numbers and cash inflow as a positive number. Designate negative numbers consistently with either a minus sign, as with –100, or with parentheses, as with (100).
- Subtract the Business as Usual cash flow from the Proposal cash flow. Never use the reverse order
To show how these conventions work in practice, consider two full-value cash flow statements:
With the information in these full-value statements, the incremental cash flow values for three line items is easy to calculate;
Incr. Revenue = Proposal – Busn. as Usual
= 300 – 250
The positive incremental value means that revenues are $50 greater under the proposal scenario than under Business as Usual
Incr. Wages = Proposal – Busn. as Usual
= (50) – (70)
Subtracting a larger negative number from a smaller negative number brings a positive result. This means that wages expenses under proposal are $20 less than wages under Business as usual. This shows how cost savings and avoided costs show up in the incremental cash flow statement.
Incr. Overhead = Proposal – Busn. as Usual
= (130) – (100)
The negative incremental value means that overhead is $30 higher under the proposal scenario than under Business as usual.
Incremental Cash Flow Statements
For Business Case Results Step 2, the analyst creates an incremental cash flow statement for each of the proposal scenarios. Exhibit 3 below shows the general approach for creating incremental statements (Exhibit 3) from full-value statements (Exhibit 1).
Exhibit 3 shows the resulting two incremental cash flow statements, based on the full-value statements in Exhibit 1.
Messages in the Incrementals
Incremental cash flow statements in Exhibit 3 carry quite a few useful messages about the cash flow figures in Exhibit 1 full value scenarios. Two such messages are, for instance, the following:
Net cash flow under Proposal Scenario 1 shows a gain of $180 over the Scenario 3 Net CF., while Proposal Scenario 2 leads to a net loss of $59 compared to Scenario 3.
Scenarios 1 and 2 both expect a 2-year net cash inflow of $280 that is not present in Scenario 3. This $280 inflow is an avoided cost for the additional hiring and salary costs planned in Scenario 3.
When an action prevents a future cost, the result is cost avoidance—if and only if the future cost is very likely, absent the action.
Both proposal scenarios in Exhibit 1, for instance, propose actions that make unnessary the $280 hiring and salary costs planned under business as usual. For scenarios 1 and 2, therefore, this item is an avoided cost. This cost avoidance belongs on the incremental summary, if and only if the new employees are certain under "Business as Usual."
Preventative maintenance for machinery 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.
Mathematically, an avoided cost appears in these comparisons in precisely the same way that cost savings appear. The difference between avoided costs and cost savings is this:
- Cost savings result from looking forward to reducing spending already underway.
- With an avoided cost, by contrast, the avoided cost increase is in the future. As a result, the "bottom line" on avoided costs has to do with an assumption:
The avoided cost is legitimate if the analyst can assume and show credibly that the cost increase is very likely, absent the proposal scenario action.
Cost savings and avoided costs turn up as line items with cash inflows on incremental cash flow statements, such as those in Exhibit 3 above. Opportunity costs, by contrast, do not appear as line items on cash flow statements.
The 3-scenario example above reveals several opportunity costs, 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 items do not carry that name on the cash flow summaries above. They emerge from the analysis by highlighting a forecast gain on one scenario that is absent in another scenario.
Avoided costs and opportunity costs, in other words, can be real, measurable, and legitimate topics for discussion. The analyst can decide 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 the Excel-based ebook and template system, Financial Modeling Pro. For a complete introduction to business case reasoning and business case proof, see the online article Business Case.