Cost avoidance

From CEOpedia | Management online

Cost avoidance is a state in which an entity spends less money. The most effective way to reduce costs is to minimize fixed costs. Increase in revenue - a situation in which the entity maximizes its revenue (T. Cooley, 2015, p. 21-24).

In order to reduce costs, it is necessary to keep regular control of expenditures (full record of expenditures) and know the total revenues in a given period. The most reliable result can be obtained from data for one year. In this case, we also analyse additional revenue (e.g. from casual work) and unexpected costs (e.g. machine maintenance) (T. Cooley, 2015, p. 21-24). However, already a few months' observation of the entity's cash flows allows us to calculate the savings ratio. The difference between the amount of income and the sum of all costs is equal to the income. Income divided by the amount of earnings and expressed as percentages shows the savings ratio (T. Cooley, 2015,p. 21-24).

Objectives of cost avoidance

The cost avoidance system means systematic search and implementation of improvements in technology and organization, as well as raising the level of knowledge and qualifications of employees in order to continuously reduce the costs of product manufacturing (R. Dunne, T. Cooley, S. Gordon, 2014, pp.14-16). Cost avoidance activities are undertaken both at the stage of product planning and preparation for mass production, as well as during production. As well as comprehensive cost management, the cost reduction account is oriented towards long term profit and increase of the company's value (R. Dunne, T. Cooley, S. Gordon, 2014, pp.14-16).

Cost reduction and standard costs

Cost avoidance uses a lot of information from standard cost accounting. On the basis of information on the current, actual individual cost of production from the base year for the manufacturing phase, information on the standard cost of the product for the following year (year 1) is prepared in the standard cost accounting system, which is transferred to working groups established in the cost avoidance system, e.g. Kaizen (P. Gauvin, 2006, p.59). This information is the basis for searching for improvements reducing the cost of manufacturing the product during the year, so changes are made on an ongoing basis in the quantity and type of used resources of the organization and processes. Information on amounts reducing the standard cost by each of the introduced improvements results from calculations which are carried out on an ongoing basis (P. Gauvin, 2006, p.59-60).

Cost calculations for new solutions are prepared on an ongoing basis and analysed by working teams, which also include management accounting specialists. This means at the same time that the cost-cutting accounting system is oriented towards many different employees (not only managers of departments and centres) and leads to greater institutionalization of knowledge in the field of cost accounting than in the case of using only traditional systems (P. Gauvin, 2006, p.60).

Methods of cost avoidance

Value engineering is a very effective method of cost avoidance through changes in the structure and composition of a product or its manufacturing method (R. Bakhshi, P. Sandborn, 2010, pp. 22-23). A way to reduce the cost may be to use cheaper materials and components. Changes in the technological process may include its simplification, acceleration or lower demand for raw materials. A very important aspect of the VE idea is the assumption that the introduced changes cannot negatively affect the quality and usability of goods (R. Bakhshi, P. Sandborn, 2010, pp. 22-23).

  • Eliminating unnecessary movements - eliminating unnecessary activities performed by employees. This can be achieved by improving the ergonomics of workstations, maintaining order and proper work standards. The 5S method (sorting, systematics, cleaning, standardization, self-improvement) is often used for this purpose. It allows to identify unnecessary activities, improve ergonomics of workstations, as well as to develop good habits among employees and increase safety (D. Nowicki,et al., 2011,pp. 117-119).
  • "No fails" philosophy - The elimination of defects increases the quality of production and helps to prevent losses. For the implementation of the "zero error" principle it is useful to implement the assumptions of Poka-Yoke, i.e. the organization of the technological process in such a way as to eliminate the human error factor. Other tools supporting the "zero error" philosophy are Computerised Maintenance Management Systems or appropriate MES modules (Manufacturing Execution System) (R. Bakhshi, P. Sandborn, 2010, pp. 22-23). They facilitate the maintenance of the infrastructure in good condition, which has a direct impact on the quality of manufactured goods and continuity of production. The use of IT systems allows to eliminate the causes and not the effects of errors (R. Bakhshi, P. Sandborn, 2010, pp. 22-23).
  • Implementing creative ideas - practically every task can be performed using alternative methods. For example, if a company wants to record the course of routes in internal transport (in order to control employees, or collect data for analysis and further optimization), instead of commercial solutions, it can use a free, mobile application for runners (D. Nowicki,et all., 2011, pp. 117-119). The source of such creative ideas should be the employees themselves. The involvement of the staff in the process of continuous improvement is one of the pillars of the Kaizen idea. Among the companies belonging to the world's leading companies in its use, each production employee generates, on average, a dozen or so ideas for improvement per year (D. Nowicki,et al., 2011, pp. 117-119).
  • Improvement of internal logistics - efficient production process requires constant supply of materials to production stands. The scale and complexity of this challenge increases with the size of the production plant (S. Gordon,et al., 2017, pp.325). The problem of production logistics intensifies in the case of expansion of the existing plant, when there is a significant disruption of the existing flow of materials and products. This sometimes results in the need for deep reorganization of transport. Optimization of logistics and its adjustment to current needs may be facilitated by IT systems of MES (Manufacturing Execution System) production execution. They allow you to track the flow of materials in the production hall in real time, inform about statuses and provide historical data for analysis and optimization (S. Gordon,et al., 2017, pp.325-327).
  • Eliminate the need for repackaging - agreeing on an appropriate, uniform format for packaging components with suppliers eliminates the time-consuming stage of repackaging. This allows materials and parts to go directly to production stations for immediate use optimization (S. Gordon,et al., 2017, pp. 327).

The benefits of cost avoidance

The cost avoidance strategy of an enterprise is tantamount to their optimisation, which brings the following benefits (M. Irshad R. Torkar, 2016, p. 34-36):

  • increase in the value of the enterprise,
  • reduction of burdens will allow to invest the saved financial resources in the development of the enterprise,
  • increase in the level of investment potential of the company,
  • increase in savings,
  • reduction of the costs of the current functioning of the enterprise, such as telecommunication costs, administrative costs, costs of office materials, real estate lease costs, identification of areas that are not crucial for the enterprise's activity (IT, accounting, marketing);
  • optimization of business processes, reorganization of strategic areas of the company's functioning, organizational structure and improvement of management;
  • optimization of employment costs and increase of employee potential through the introduction of flexible forms of work;
  • optimization of production costs, changes in cost calculation, reduction of energy costs, improvement of purchasing process and supply chain management, which is particularly important in manufacturing companies;
  • optimization of logistics and distribution costs, reduction of transport costs through more effective fleet management and logistics planning;
  • optimization of interest costs, restructuring of existing debt, use of innovative forms of financing enterprises (M. Irshad R. Torkar,2016, p. 34-36).

Examples of Cost avoidance

  • Negotiating lower prices for goods and services: This is one way to reduce costs by negotiating with suppliers and vendors to get lower prices for goods and services.
  • Outsourcing: Outsourcing certain services can be a cost-effective way to save on labor and other overhead costs.
  • Automation: Automating processes such as payroll and invoicing can help to reduce human error and save time and money.
  • Reducing energy consumption: Reducing energy consumption can help to lower electricity and fuel costs.
  • Investing in efficient equipment: Investing in more efficient equipment and technology can help to lower operating costs in the long run.
  • Negotiating better payment terms: Negotiating better payment terms with creditors can help to reduce interest costs and save money.
  • Utilizing technology: Utilizing technology such as artificial intelligence and cloud computing can help to reduce costs associated with labor and other overhead costs.

Limitations of Cost avoidance

Cost avoidance is a practical approach to reducing expenses, but it has its limitations. These limitations include:

  • Difficulty in finding cost saving opportunities: Identifying where cost savings can be made is often a difficult and time consuming process.
  • Difficulty in assessing whether a cost saving measure is worth the effort: It can be difficult to accurately assess the potential benefits of a cost saving measure.
  • Difficulty in measuring the effectiveness of a cost saving measure: It can be difficult to measure the effectiveness of a cost saving measure once it has been implemented.
  • Difficulty in determining the long-term impact of a cost saving measure: It can be difficult to determine the long-term effects of a cost saving measure.
  • Difficulty in maintaining cost savings: It can be difficult to maintain cost savings over the long run.
  • Potential for unintended consequences: Cost avoidance measures may have unintended consequences that can inadvertently increase costs.

Other approaches related to Cost avoidance

In order to reduce costs and ensure cost avoidance, there are a few approaches to consider. These include:

  • Implementing changes in production processes and increasing efficiency. This involves streamlining production processes, reducing waste and utilizing more efficient methods of production.
  • Utilizing advanced technology. Companies can reduce costs by investing in technology that can help them automate processes, increase efficiency, and reduce labor costs.
  • Utilizing alternative sources of energy. Companies can save money by switching to renewable energy sources such as solar or wind power.
  • Negotiating with suppliers and vendors. Companies can negotiate better prices or terms with suppliers and vendors to reduce their costs.
  • Reducing overhead costs. Companies can reduce overhead costs such as rent or utilities by relocating or renegotiating contracts.

In summary, cost avoidance can be achieved through a variety of methods such as improving production processes, utilizing advanced technology, utilizing alternative energy sources, negotiating with suppliers and vendors, and reducing overhead costs.


Cost avoidance — recommended articles
Capacity analysis — Process innovation — Target cost — Dependent demand — Direct labor efficiency variance — Resources and capabilities — Hidden cost — Controllable costs — Differential costing

References

Author: Dawid Misiura

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