Understand cost savings vs. cost avoidance in procurement and how each distinctly impacts an organization’s approach to cost management.
By Hugo Britt | September 21, 2023
“Hey honey, I just saved our family over $100,000!”
“Really? How?”
“I just decided not to buy myself a Tesla Model S!”
“…I don’t think that’s a cost saving. It’s more like a cost avoidance.”
Cost savings vs. cost avoidance
Confused about the difference between cost savings and cost avoidance? You’re not alone. In this article, we clear up the difference between the two, their impact on your organization’s P&L, discuss how to choose the right strategy, and take a look at why some procurement professionals find the concept of cost avoidance controversial.
While cost savings and cost avoidance may seem interchangeable at first glance, they represent distinct approaches to cost management.
Let’s start by listing the levers you can pull to achieve each approach.
Cost savings vs. cost avoidance may seem interchangeable at first, but they represent very different approaches an organization may tackle cost management.
Understanding cost savings
Cost savings, as the term suggests, refers to the reduction in expenses achieved through various procurement actions. These actions typically involve negotiating better deals with suppliers, optimizing procurement processes, and finding cost-efficient alternatives for goods and services.
Here are some cost-saving levers you can pull:
Negotiation and supplier management
Negotiation skills are at the heart of cost savings. Procurement professionals work closely with suppliers to secure better pricing terms, discounts, and favorable contract terms. Building strong relationships with suppliers can lead to long-term cost savings opportunities.
Volume discounts
One common way to achieve cost savings is by leveraging the purchasing power of the organization. Buying in bulk or consolidating purchases across departments can often lead to volume discounts, reducing the cost per unit. To supercharge volume discounts, consider joining a group purchasing organization like Una.
Competitive bidding
Encouraging suppliers to compete for your business through competitive bidding processes can result in more competitive pricing and better terms.
Process efficiency
Streamlining procurement processes and eliminating inefficiencies can reduce the time and resources required for procurement activities, contributing to cost savings.
Total cost of ownership (TCO) analysis
TCO analysis considers not only the purchase price but also the ongoing operational costs associated with a product or service. It helps procurement professionals make informed decisions that lead to long-term cost savings.
Understanding cost avoidance
Cost avoidance, on the other hand, focuses on preventing unnecessary expenditures rather than seeking direct reductions in costs. It involves identifying and mitigating potential risks and inefficiencies in the procurement process.
Here are some ways to avoid costs:
Risk management
Cost avoidance starts with a thorough assessment of potential risks in the procurement process. This includes identifying supplier risks, regulatory compliance risks, and market volatility risks. By addressing these risks proactively, organizations can avoid costly issues down the road.
Supplier evaluation
Careful supplier selection is crucial for cost avoidance. By evaluating supplier financial stability, reputation, and compliance with industry standards, procurement professionals can minimize the risk of disruptions and costly disputes.
Contract management
Well-structured contracts are essential for cost avoidance. Contracts should include clear terms, dispute resolution mechanisms, and penalties for non-compliance. A solid contract can help prevent costly legal disputes and disruptions to the supply chain.
Compliance and ethics
Ensuring that all procurement activities are conducted in compliance with laws and ethical standards is a key element of cost avoidance. Legal issues, fines, and reputational damage can result from non-compliance.
Supplier diversity
Diversifying the supplier base can be a cost avoidance strategy. It reduces dependence on a single supplier and mitigates the risk of supply chain disruptions caused by factors such as natural disasters or geopolitical events.
Both cost savings and cost avoidance are essential in procurement, but they serve different purposes and have distinct implications for financial reporting.
What about the P&L?
Cost avoidance typically does not directly impact the profit and loss (P&L) statement in the same way that cost savings do. Cost avoidance refers to actions taken to prevent potential future costs, such as risks, disputes, or inefficiencies from materializing. While these actions can indirectly influence the P&L statement by mitigating potential losses or expenses, they do not directly appear as a line item.
In contrast, cost savings directly impact the P&L statement by reducing immediate expenditures, which can result in higher profits or lower losses. Cost savings achieved through negotiation, process optimization, or better pricing from suppliers can lead to reduced operational expenses, which directly affect the bottom line.
So, while cost avoidance is a valuable strategy for protecting the financial health of an organization in the long term, its impact on the P&L statement is more indirect. Cost savings, on the other hand, have a more immediate and quantifiable effect on the P&L. Both strategies are essential in procurement, but they serve different purposes and have distinct implications for financial reporting.
Why does this matter? Depending on procurement’s reporting lines, the function may be under pressure from the Chief Financial Officer (CFO) to focus only on initiatives that will have a direct, reportable impact on the bottom line.
The debate around cost avoidance
Some procurement professionals have strong opinions about cost avoidance and argue that they don’t represent genuine savings.
Here’s why:
Lack of immediate tangibility
Cost avoidance often involves taking preventive measures or making investments to mitigate potential future risks or expenses. Unlike cost savings, which provide immediate reductions in current expenditures, cost avoidance measures may not yield tangible and quantifiable savings on the balance sheet in the short term. This can lead some to question the validity of this strategy.
Difficulty in measurement
Cost avoidance can be challenging to measure and attribute to specific actions or decisions. It deals with the prevention of negative outcomes that may or may not occur. The absence of concrete metrics and clear cause-and-effect relationships can make it seem less substantial to some stakeholders.
Choosing the right strategy
The next step involves knowing when to employ each strategy. The choice often depends on the specific circ*mstances and objectives of a procurement project.
Cost savings are typically employed when the primary goal is to reduce immediate procurement expenses. This strategy is suitable for organizations looking to lower their operational costs, negotiate better pricing, or optimize their purchasing processes.
Cost avoidance is more focused on minimizing risks and potential future costs. It is suitable when dealing with critical supplies or services where disruptions or quality issues can have significant consequences. Cost avoidance strategies are also important when regulatory compliance and ethical considerations are top priorities.
Case study: cost savings vs. cost avoidance
Let’s explore a real-life example to illustrate the difference between these two strategies:
Imagine a manufacturer is considering two options for a critical piece of equipment: Supplier A offers a lower upfront cost but has a history of delayed deliveries and quality issues. Supplier B, on the other hand, offers a higher initial price but has a reputation for on-time deliveries and superior product quality.
In this scenario, choosing Supplier B represents a cost avoidance strategy. While it may involve higher upfront costs, it minimizes the risk of disruptions to operations, costly maintenance, and potential safety liabilities associated with subpar equipment. On the other hand, selecting Supplier A may result in short-term cost savings but carries the risk of long-term expenses due to equipment failures and delays.
The best of both worlds
In practice, successful procurement often involves a combination of these two strategies.
Procurement professionals must assess each situation, weigh the potential benefits and risks, and make informed decisions that strike the right balance between cost savings and cost avoidance.
To help with your cost savings initiatives, use our free calculator to see how much you could be saving by partnering with a GPO like Una:
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