Avoided cost, cost savings, opportunity cost illustrated examples electricity song

###

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

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

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.

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.

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. 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?

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:

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

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:

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.