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Cost Reduction vs Cost Avoidance


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Cost Reduction is a tangible (or hard savings) benefit from a project. It reduces the cash outflow of the organization and thus gets reflected in the financial statements.

 

Cost Avoidance is an intangible (or soft savings) benefit from a project. It avoids incurring a potential cost in the future. Because cost avoidance does not impact the current cash flows, it never gets reflected in the financial statements.

 

An application-oriented question on the topic along with responses can be seen below. The best answer was provided by Glory Gerald on 13th Nov 2020.

 

Applause for all the respondents - Rajesh Patwardhan, Glory Gerald, Aritra Das Gupta, Ibukun Onifade.

 

Also review the answer provided by Mr Venugopal R, Benchmark Six Sigma's in-house expert.

Question

Q 313. What is the difference between Cost Reduction and Cost Avoidance? Highlight using examples.

 

 

Note for website visitors - Two questions are asked every week on this platform. One on Tuesday and the other on Friday.

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Cost Reduction Vs Cost Avoidance

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Examples giving comparison of Cost Reduction & Cost Avoidance
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Other Examples of Cost Reduction & Cost Avoidance

 

Cost Reduction:

• Reduction of Overtime in a company

• Partnerships where a company can find a partner to invest in certain assets or services in order to reduce costs.

• Location Strategy of a company – migration of work to a new location due to availability of cheap labor when compared to home location.

 

Cost Avoidance:

• Investing in new technology (one time investment) as it eliminates the need of spending on compensation costs in future for additional workers.

• Looking for value added services that can come at minimal or no cost to the company as it avoids additional spending on the same in the long run. For instance, a company looking to purchase fleet vehicles can opt for those dealers who offer free oil changes , etc.

• Repairing a vehicle/equipment rather than allowing employees operate vehicles or equipment that are in poor conditions that could also increase the chance of an accident for which the cost is way too high when compared to repairing a vehicle/equipment.

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Benchmark Six Sigma Expert View by Venugopal R

Lean Six Sigma and Business Excellence professionals often come across improvement projects that are important but sometimes difficult to justify the gains to get a CFO approval. A “Cost avoidance” related projects is perhaps one such situation. I recall a situation where the customer has a penalty clause if the Quality level of our output falls below 98%. For many years, we have been managing very well, barring some occasional blips and maintained Quality levels high enough to avoid the penalties. One fine day, the customer revises the SLA and raises the Quality requirement to 99.5% and gives us 3 month’s time to attain the same. This forces us to frantically work on an improvement project, which if successfully done on time, will help us to ‘avoid the cost’ of penalty. However, the finance staff will not see it reflected as a cost saving on their books.

 

Now, imagine another situation where we are already incurring losses, as a result of being penalized for not meeting the Quality score. If a project is taken to address this issue and we succeed in getting rid of the penalty, this will obviously be seen as a saving on the Finance books and would probably get appreciated better than the previous case.

 

“Cost reduction” refers to the reduction of a cost that is already being incurred. It is like getting relieved from a pain that we are already suffering. “Cost avoidance” refers to efforts that will avoid a potential cost, which would be incurred, if the action is not taken. It is like preventing us from a pain that we are likely to suffer if we do not act on time.

 

DFMEA and PFMEA are tools that help us to prevent potential failures and thus help in “cost avoidance”. Fault tree analysis and corrective action are efforts that help us to solve an existing problem and hence result in “cost reduction”.

 

However, once we implement a “cost reduction” activity, it has to be regularized and implemented as a "cost avoidance" on a similar new process or product design. Then on, it becomes an established practice and may no longer be perceived as a “cost avoidance” action when repeated.

 

A project that addresses and removes non-value adding steps in a process drives “cost reduction”, where as a process or layout that is designed right in the beginning keeping away all those NVAs, will be considered as “cost avoidance” action.

 

If a machine is producing more rejects and costs money, getting it repaired could result in “cost reduction” by eliminating the reject generation. However, a good Preventive Maintenance program would have been a “cost avoidance” initiative, as it would have prevented the reject generation in the first place.

 

A greater awareness and appreciation of “cost avoidance” initiatives in an organization will encourage superior thinking and preventive oriented actions. On the other hand, poor organizational awareness of “cost avoidance” will discourage preventive oriented initiatives. In this context let me mention about the Cost of Quality (COQ), which has 3 broad components viz. Prevention costs, Appraisal Costs and Failure Costs. The Appraisal and Failure costs are often referred to as ‘Cost of Poor Quality’. (COPQ). The prevention costs should ideally be considered as ‘Investments’ that help in avoiding the COPQ. However, usually, the information on COPQ is more easily available in an organization than the ‘Prevention Costs’.

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Businesses globally work on the principle of win work (top line) - do work (execution) - make money (bottom line).

Businesses constantly endeavor to maximize top line and increase bottom line.

 

Execution of work requires companies to incur costs. For a manufacturing company, it may be capital expenditure with operating costs. For construction businesses, costs relate to hiring equipment, skilled and unskilled workforce etc. For Asset operators, for exampl e.g. airport operators, costs will include money spent on operations including the upkeep/ maintenance/ security/ staff both technical and non-technical.

 

Briefly, Profit = Business revenu - Cost. To maximize profits, you increase business revenue or reduce costs. 

 

If an airport is using physical paper tags for check-in systems, there is a huge direct and indirect cost associated with buying tags and indirect costs in disposing off the tags apart from huge carbon and water footprint associated with paper tags.

 

If airports use face recognition systems instead of using paper tags all these direct and indirect costs are eliminated. However, the airport will have to incur costs and maintenance of face recognition system, which may reduce operational costs. Bangalore airport is already doing this.

 

If a pipe needs to traverse across a river, you may have to build a bridge with all its apputenace and maintenance access through the bridge. An engineer can reduce the cost of the bridge by choosing structural system like an Arch structure to reduce the cost instead of conventional beam-slab type of bridge. If, instead, the same pipe can be shaped in an Arch form to span across the river, cost of bridge is eliminated. 

 

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  Cost avoidance includes steps which are taken which will help reducing the cost that will be incurred by an organization in future. Cost avoidance aims at having a minimal increase in cost but reducing future cost.

 

Examples of Cost Avoidance :- 

 

1. Making changes in the machinery which might increase the cost initially but will bring down cost of production in future

 

2. Setting up a new Quality department in a leather industry which can help in reducing the losses incurred due to the cargo being rejected due to Quality reasons.

 

3.Investment by a company in lean training which will help in cost reduction in the long run as there will be individual who will look for waste reduction in each of there departments post completion of the training

 

4. Installing a Smoke detector in a factory set up which can help in averting a major catastrophe

 

5. Bio Metric system for 10,000 strong Steel company so that tracking of attendance and man hours becomes easy. This will help in better planning and will save a lot of time and cost if this was done manually

 

6.Using Cisco systems for meeting across globe which helps to reduce cost if the same meeting was held with each member being physically present.

 

7. A software company doing testing for an application before it is released .This avoids any cost in future if there is some bug not identified at the onset. The same can lead to customer dissatisfaction & losses for the organization

 

8. A mobile manufacturer does a product testing of its new smartphone before it is launched. This allows them to fix any issues before the customer buys the product. If this is not done and there is a customer complaint then the result can lead a company losing its market share 

 

Cost avoidance is never reflected in the budget or in the Financial statements.

 

Cost Savings :- 

 

Cost Saving is also known as either a Hard or a Soft Saving. This deals with any actions that lower debt levels,current spedings or investments. The Financial statement and budget reflects the cost savings and are extremely beneficial with regards to the financial health of a process.

 

Examples of Cost Savings - 

 

1.Price Negotiation - A company might be using a vendor and there can be bulk purchase. This results in a price negotiation and the vendor lowers the prices which leads to cost savings 

 

2.New Contract & Contract Renewal - This can be great scope for cost savings

 

3.Partnerships - A company chooses to partner with Cloud Computing company which will help in cost reduction by reducing the infrastructure cost in future

 

4.Outsourcing Call center division of a insurance company which will help in reducing operation cost and hence this will help in reducing overall cost for the organization 

 

5.Lowering marketing cost by using digital advertisement instead of going to a marketing firm. This will help in reducing cost and is an example of cost saving

 

Cost Saving is calculated in %. The same is calculated by

Original Cost - New Cost = Price difference , Price difference /Original Cost *100 = Cost Saving 

 

 

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Cost avoidance measures are action taken to avoid having to incur costs in the future. The benefits from cost avoidance can not be shown on financial statements and cannot be reflected in the budget. They are more difficult to estimate.

EXAMPLE

In a manufacturing setup, management may decide to reduce spending on preventive maintenance activities because the current frequency does not appear justifiable. Some parts may have been scheduled to be changed 6 times a year, perhaps from manufacturers’ recommendations or as outcomes from previous improvement projects. This high frequency maintenance activities might be resulting in huge repairs an maintenance expenditures for the firm. Reducing the frequency will be a cost reduction measure. This will be refelected in the operation expenses portion of the financial statement.

On the other hand, after some time, it might be discovered in the same company the unplanned downtime has increased in the factory and requires urgent and drastic action. Preventive maintenance activities might need to be reviewed again. This time around, maintenance expenditure will be increased to avoid the higher cost that will be incurred because of the high unplanned breakdowns. The financial benefit due to decrease in unplanned downtime will be cost avoidance.

Further examples of cost reduction

Ø  Reduction of overtime hours

Ø  Reduction of manpower

Ø  Negotiation of lower rental costs for equipment

Further examples of cost avoidance

Ø  Reduction of proposed price increase of a raw material

Ø  Negotiating long term contracts with price protection provisions

Ø  Negotiating additional services from service suppliers at no extra cost

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Glory has provided the best answer to this question by explaining both the terms and by providing multiple examples for both. All other answers are worth a read for the brilliant examples quoted. 

 

Also review the answer provided by Mr Venugopal R, Benchmark Six Sigma's in-house expert.

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