When a business owner sits down to consider reducing costs, it's wise to keep in mind that cost reduction comes in three different types: cost savings, avoided costs and opportunity costs. Which of these types of cost savings offers the greatest benefits depends on the situation and the business owner's objectives.
Cost saving can occur when a business reduces an existing expense. For example, swapping out incandescent bulbs for LEDs can result in a lower monthly electric bill.
An avoided cost, on the other hand, is one that is not incurred. For example, spending on cybersecurity can avoid costs of a data breach.
Opportunity cost is sustained when a business loses future gain by choosing one action over another. For example, selling land that could have hosted a new store trades opportunity cost for cash today.
To make the most of cost-management efforts, Modesto, California-based small business advisor Gary McKinsey suggests keeping these types of cost savings in mind.
“When a client is considering cutting expenses, I always ask them to look beyond the immediate cash savings to be sure there is not an unintended consequence that will cost them more time and money in the future," McKinsey says. “Once they have determined that there are not any detrimental consequences, or they can successfully deal with the consequences, then it makes sense to cut the expense."
Applying Cost Savings
The best time for cost saving, McKinsey says, is before you need to.
“It typically comes up at the wrong time, when the business owner notices that cash flow is decreasing," he explains. “They're not quite sure what to do, so they start cutting expenses. Typically, that's too late to make good decisions, because now they're in a panic mode."
—Gary McKinsey, small business adviser
One possible solution is doing some forecasting, taking into account seasonal fluctuations and business cycles to determine when cost cutting will be needed and what types of cost savings makes sense.
The first candidates for cost cutting, McKinsey says, should typically be materials and purchasing. One common scenario is overbuying in order to take advantage of what seems like a good deal. But this can tie up cash and, in the event of an unexpected slump, make it necessary to lay off workers, shutter facilities or do other kinds of cost-cutting that can make it harder to ramp up when business returns, McKinsey says.
It may be better to purchase materials and supplies as needed than to build up inventory in advance of needs that may never arrive.
Avoiding Cost Applications
Casey McClure is the vice president of Blueberry Diapers, a Knoxville, Tennessee-based maker of cloth diapers. He says the company has spent significantly on digital printers that let them perform work in-house that they formerly outsourced to providers in Asia.
But acquiring the printers also meant recognizing cost avoidance as one of the types of cost savings.
“We have $250,000 invested in digital printing products," McClure says. “These digital printers are very sensitive. We have to spend money to maintain the machines. If not, we'll have to spend thousands more."
Opportunity Cost Examples
Opportunity cost saving is often less obvious than other types of cost savings. Blueberry Diapers had to consider opportunity cost when looking into awarding a distributorship in an international market.
The company had recently signed up its first retailer in Israel. Sales there were going well when a distributor approached the company to ask about servicing the market for them.
“That will cost more off the top, in exchange for potential[ly] more sales," McClure explains.
This cost-savings exercise involved comparing the extra 10 percent the distributor would get to the anticipated increase in sales. In the end, they decided the opportunity cost was higher if they passed on the deal. They signed the distributor and Israel sales rose more than 40 percent.
“Those are the types of decisions we have to make," McClure says, “Do we give up the sale we're doing now for higher potential sales down the road?"
Choosing The Right Type of Cost Savings
The different types of cost savings can help business owners by presenting them with options for managing cash that go beyond simple cost cutting. For instance, sometimes slashing expenses can save money now at the cost of opportunity later.
As an example, McKinsey says business owners feeling pressure to reduce costs often trim workers they really can't do without.
“Don't do the immediate knee-jerk reaction," he says, "If you let this person go, you are saving on wages and benefits now, but 60, 90 or 120 days down the road you may find out something isn't being done that is going to cost more money."
Technology is often helpful when deciding which of these types of cost savings to focus on. Blueberry Diapers uses NetSuite ERP software to provide them with real-time financial data that aids in forecasting and spotting cost crunches before they happen.
“We don't have to wait until the end of the period," McClure says. “If we see something falling behind, we can make an adjustment."
By devoting a little extra time to these decisions, business owners can make better choices about which type of costs savings is best for them.
Read more articles on managing money.
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