The CFO Had a Problem with Avoided Costs A routine oil change is a familiar example of cost avoidance. Small investments in preventative maintenance avoid the much larger cost of engine replacement later. I spoke recently with a project manager who had been denied project funding. The Project Management Office—and the company CFO in particular—had just turned thumbs down on the manager's Stage-0 business case. Why? Where were the red flags? Learn how to calculate and present relative costs in the online article: Cost savings, avoided costs, overview in the Business Encyclopedia The manager's case projected an attractive profitability (ROI) and very acceptable risks for the proposed project. In the CFO's view, however, there was just one problem: Avoided costs. Profitability and other business benefits depended heavily on projected avoided costs. For this CFO, avoided costs simply were not legitimate business case benefits. The project manager was trying to decide whether to abandon the case, or to challenge the CFO challenge the CFO's reasoning and appeal the decision. In fact, avoided costs, opportunity costs, and cost savings, can all play an important role in business planning, budgeting and decision support. 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. That is unfortunate because all of these terms carry useful information for business analysis and decision support when understood and used properly. One reason for the confusion sometimes surrounding these cost-related concepts is that all three terms are relative terms. They have reality, that is, and they can be measured only when one business outcome (or scenario) is compared to another outcome. Very briefly, these terms mean the following: Cost savings refers to a cost (expense) already incurred, or being paid. If a driver trades the currently owned vehicle for a more fuel efficient vehicle, while maintaining the same driving habits, the driver can expect a cost savings in fuel costs. An avoided cost is also a cost savings, but the reference is to a cost (expense) not yet incurred. Preventative maintenance for the vehicle (e.g., regular oil changes) avoids the future cost of engine replacement, which is certainly coming if preventative maintenance is omitted. Opportunity cost refers to a foregone gain that follows from choosing an outcome. The gain would have been realized had a different action (outcome, or scenario) been chosen. Suppose for instance, a collector of classic automobiles offers a very large sum to purchase the driver's car. The driver must choose between two outcomes: (1) Continuing to own and drive the car, or (2) selling the car to the collector. The driver may see many other in choosing option 1, turning down the offer, but option 1 also brings a a a very large and real opportunity cost. Learn how to calculate and present relative costs in the online article: Cost savings, avoided costs, overview in the Business Encyclopedia Take Action! Learn and practice proven methods for building your cases at a Building the Business Case Seminar. Learn more about business case design from one of our books, the Business Case Guide, or the most frequently cited business case authority in print, Business Case Essentials. By Marty Schmidt. Copyright © 2004-2016. Published by Solution Matrix Limited. Find us on Linkedin Google+ Facebook Marty Schmidt | October 6, 2016 at 6:17 am | URL: https://www.business-case-analysis.com/blog/?p=3598 |