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Cost Reduction and Cost Avoidance

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.

A cost reduction, which is a "hard" cost saving, usually takes the form of a tangible year-over-year bottom-line cost reduction such as:

  • the direct reduction of a capital or operating expense, such as a decrease in the annual lease payments, a reduction in the telecommunications cost, or a reduced annual IT maintenance fee
  • a process improvement that results in real and measurable cost reductions, such as a process improvement that allows more units to be produced on the line in the same time-frame (productivity improvement) and/or with the same amount of raw material inputs (waste reduction)
  • a net reduction in prices paid for the raw materials procured when compared to prices paid in the previous year

A cost avoidance, which is a "soft" cost saving, usually takes the form of a more intangible cost avoidance, which does not show up on, but materially impacts, the bottom-line cost such as:

  • a delayed price increase, despite rising costs on the commodity markets
  • a negotiated purchase price that is lower than the initial quote
  • additional value-add services in a contract that are free-of-charge
  • long term contracts with price-protection provisions
  • the identification of a new production process that supports utilization of a lower cost material

If you haven't conducted a supply chain efficiency audit recently, chances are that your supply chain is ripe with cost reduction and cost avoidance opportunities. Start by looking at the six fundamental sources of cost:

  • labor (raw material collection, processing, & handling costs)
  • parts (design, raw material, component, & production costs)
  • operations (inventory, distribution, & overhead administration costs)
  • transportation (loading, shipping, and insurance costs)
  • buying (negotiation, requisition, approval, receipt, reconciliation, and payment costs)
  • selling (negotiation, processing, reconciliation, and collection costs)

And ask the following questions to help you identify where you are most likely to be hemorrhaging cash:

  • Are we applying lean and six sigma methodologies? Where might they be appropriate?
  • What indirect materials and service spend categories are not being (actively) managed?
  • Are we employing the latest technologies to help us analyze complex direct materials and strategic part categories?
  • Are we employing best-in-class processes and supporting technologies in our day to day operations?
  • Do we have sufficient (at least 90%) visibility into our spend and are we taking full advantage of that visibility to identify new cost savings opportunities on a regular basis?
  • Are we taking a Total Cost of Operations (TCO) perspective when computing our operational costs and a Total Value Management perspective when computing the value of each prospective purchase?
  • Are we outsourcing non-core categories and operations to a provider who can give us better service at a lower cost of TCO?

Once you've identify those areas that are hemorrhaging cash, you reduce the costs by identifying cost reduction strategies and change management plans to implement those strategies. The following strategies are often good starting points:

  • Labor (talent management and contingent workforce management)
  • Parts (strategic sourcing, design for supply, and enterprise cost management)
  • Operations (manufacturing intelligence, best practice implementation, supplier management)
  • Transportation (distribution network re-design, shipment consolidation, multi-mode utilization)
  • Buying (spend analysis, strategic sourcing, decision optimization)
  • Selling (market intelligence, partnerships, green and sustainable, brand building)

In addition, you should consider bringing in some external expertise to help you with this effort, as consultancies that live and breathe cost reduction are often able to quickly identify significant cost savings opportunities and help you realize them faster, and at higher rates of return, than internal efforts.

For more information, I recommend the Cost Reduction and Avoidance wiki-paper, the CAPS publication on Defining Cost Reduction and Cost Avoidance that inspired the wiki-paper, the Aberdeen study on Supply Chain Cost Cutting Strategies, and the following blog posts:


 


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