Cost Avoidance and Cost Reduction

Cost Avoidance – involves finding acceptable alternatives to high-cost items and / or not
spending money for unnecessary goods and services. Avoiding one cost may require incurring an
alternative lower cost.

Example:
 The older buildings of an entity are far less energy efficient than the newer ones. The
latest use natural and LED light in lieu of electrical lights and recycle rain water for
property usage.

Cost Reduction – the intent is to lower costs. Benchmarking is especially important in this area
so that companies can become aware of excessively high costs.

Benchmarking – A measurement of the quality of an organization's policies, products, programs,

strategies, etc., and their comparison with standard measurements, or similar measurements of its
peers.

The objectives of benchmarking are (1) to determine what and where improvements are called
for, (2) to analyze how other organizations achieve their high-performance levels, and (3) to use
this information to improve performance.

Companies can reduce costs by outsourcing functions such as data processing, legal, and
distribution rather than maintaining internal departments.

Example:

 Developing a software to manage energy costs. This technology may be linked to an

employee ID card so that when the card is swiped, room lights are turned on or off and
room temperature is adjusted up or down.
 Firms having their own in-house studios and staffs and provide customized web- based
training to new employees. Although the cost of producing an online presentation is high,
the firms believe the cost is justified because the presentation can be used multiple times
at very low cost.
Managing a Cost Control System

Step 1: Understand the type of costs incurred by an organization.

Spend analysis – A spend analysis is a process for analysing the historical spend (purchasing)
data of an organisation to provide answers to questions concerning spend visibility, compliance
and control (Pandit and Marmanis, 2008).

Example:
Are the costs under consideration fixed or variable, product or period?
What are the drivers of those costs?
From whom were purchases made?
When were purchases made?

Step 2: Communicate the need for cost consciousness to all employees. Employees must be
aware of which costs need to be better controlled and why cost control is important.

Step 3: Educate employees in cost control techniques, encourage suggestions on ways to control
costs, and motivate employees to take the concepts to heart. Incentives can range from simple
verbal recognition to monetary rewards to time off with pay. Managers must also be flexible
enough to allow for changes from the current method of operation.

Step 4: Generate reports that indicate actual results, compare budget to actual, and calculate
variances. Management must evaluate these costs to determine why costs were or were not
controlled in the past. Such analysis can provide insight about costs drivers so that activities
driving costs can be better controlled in the future.

Step 5: Develop a view that the cost control system is a long-run process, not a short-run
solution. Organizations need “to examine new kinds of questions, learn to experience time
differently (long-term solutions versus quick fixes). And notice how systems work.” Proposed
cost control should be assessed using realistic circumstances rather than improbable assumptions.

Following these steps will provide an atmosphere conducive to controlling costs as effectively as
possible and to deriving the most benefit from costs incurrence. A cost-benefit analysis should be
performed before a commitment is made to incur a cost. Costs should also be incorporated into
the budgeting system because costs cannot be controlled after they have been incurred. Future
costs, on the other hand, can be controlled based on information learned about past costs. Cost
control should not cease at the end of a fiscal period or because costs were reduced or controlled
during the current period. Managers are charged with planning and controlling the types and
amounts of costs necessary to conduct business activities. Many activities required to achieve
business objectives involve fixed costs. All fixed costs can be categorized as either committed or
discretionary.

Cost containment can prove very effective if it can be implemented. However, when cost
containment is not possible, cost avoidance strategies may be applied instead.

Cost reduction can be generally defined as the act of cutting costs to improve profitability.
Cost reduction is often confused with cost avoidance, which is more properly defined as the act of
eliminating costs or preventing their occurrence in the first place. Both types of cost control, which
are two sides of the cost containment coin, are important and necessary for a company that wants
to achieve and maintain profitability, especially in a weak economy.

Questions:

1. It is an act of cutting cost to improve profitability

A: Cost reduction
2. It is the act of eliminating costs or preventing their occurrence
A: Cost avoidance
3. It is a process for analyzing the historical spend (purchasing) data of an organization to
provide answers to questions concerning spend visibility, compliance and control.
A: Spend Analysis
4. A measurement of the quality of an organization's policies, products, programs, strategies
and their comparison of standard or similar measurements of its peers.
A: Benchmarking
5. True or false: Past costs, can be controlled based on information learned about future costs.
A: False