Some of the primary variables for procurement professionals are keeping costs down, promoting efficiencies in operations, and having healthy finance. By utmost concerns, businesses should be interested in making sure they understand the different distinctions between cost savings and cost avoidance. Though both are aimed at reducing financial outlays, they play distinct roles in the procurement process.
In the following article we will examine cost savings vs cost avoidance — their calculation, and their real-life applications concerning delivering value to small to medium-sized businesses. This guide will assist in managing costs more effectively to secure greater control over present and future spending levels.
What is Cost Avoidance?
Cost avoidance is about taking proactive actions to mitigate future costs or prevent price increases from occurring. It doesn't produce direct cost savings right away but helps prevent higher spending by reducing expected future expenses. Essentially, cost avoidance aims to mitigate or prevent future expenditures by implementing cost avoidance strategies that anticipate changes in market conditions, operational requirements, and other external factors.
Imagine a company that purchases office supplies on a regular basis and negotiates a long-term contract to hold its purchase prices steady. If such a negotiation has brought advantage, the organization now enjoys current rates in order to outlast any possible price hikes that inflation or increased raw material costs may produce. This is cost avoidance.
How to Calculate Cost Avoidance?
Calculating cost avoidance requires estimating the costs likely to be incurred if no proactive solution was put in place. There are methods to calculate both the amount and the percentage.
Cost Avoidance as an Amount
To calculate cost avoidance as an amount, follow these steps:
- Determine the cost without the actions taken.
- Subtract the actual cost protected from the anticipated future costs.
Formula:
Cost Avoidance as a Percentage
And the formula to calculate cost avoided as a percentage is:
It shows the percentage of costs avoided as compared to what could have been expended.
How is Cost Avoidance Used?
As mentioned, cost avoidance is an important metric and the procurement department should monitor it regularly. Let's look at some scenarios where companies can protect themselves from future financial fluctuations.
- Long-term agreements. Fixing the prices for a year or more can stop there being any price increases in the future.
- Supplier diversification. Sourcing from multiple suppliers prevents dependency on a single supplier, and helps in averting a supply chain disruption.
- Negotiating better terms. Preventing future increases in operational costs by negotiating terms that align with a company’s financial strategy.
But even though cost avoidance is valuable for both large enterprises and SMBs, its delayed financial visibility can pose challenges for smaller businesses. SMBs often prioritize immediate cost savings to manage tight budgets and demonstrate quick financial impact.
What is Cost Savings?
Cost savings, on the other hand, represent the actual reduction in costs that occurs as a result of various procurement strategies. Unlike cost avoidance, actual cost savings result in direct financial benefits here and now. These might arise by way of price negotiation, process optimization, or strategic sourcing.
According to recent market reports, cost savings are one of the top priorities for procurement professionals. A 2024 survey by The Hackett Group found that procurement executives have elevated cost savings to their foremost priority. This marks a prominence for cost reduction, driven by factors such as inflation, budget pressures, and recession risks. Notably, 40% of participants anticipate an increase in purchase cost reduction efforts compared to the previous year.
How to Calculate Cost Savings?
Calculating cost savings can also be done in terms of both amount and percentage. By identifying where costs have been reduced, procurement teams can measure the effectiveness of their cost saving strategies.
Cost Savings as an Amount
To calculate cost savings as an amount, you need to:
- Determine the original cost. Discover the amount of price for a good or service before any reductions in the sales process.
- Identify the new cost after savings. This is the price given after any savings techniques.
- Subtract the new cost from the original cost. This will give you the cost savings amount.
Formula:
Cost Savings as a Percentage
The formula to calculate cost savings as a percentage is:
This percentage shows how much of the original price was reduced.
Examples of Cost Savings
To cite a few examples, here are some common strategies employed by procurement managers to save costs:
- Price Negotiations (RFQs). Request for Quotations (RFQ) processes allow procurement teams to invite multiple suppliers to submit competitive bids for the same goods or services. By providing transparency and competition between different suppliers is leveraged to establish favorable prices and terms. Implementing a structured RFQ process alone can significantly reduce the unit price from initial proposed cost by 5% to 15%, depending on market cycle and spend. In addition, incorporating performance-based clauses into contracts further enhances cost control.
- Bulk Purchases Discounts. Volume buying agreements can reduce certain costs. Suppliers are often willing to offer discounts of 10–20% or more for larger, consistent orders. The strategy is another way for eliminating recurring order-processing costs and saving on freight and handling costs. Many companies plan such supplies more accurately because they have used past consumption data. It brings about competent bulk buying plans.
- Procurement Optimization with Technology. Digital procurement tools like e-sourcing tools, spend analytics, and financial management systems reduce workloads, cycle times, and pricing inefficiencies significantly. In the same stroke, automation in purchase orders and approvals will also eliminate gaps and lower error rates, contributing to better operational efficiency.
Cost Avoidance vs Cost Savings: Summarizing Key Differences
Each of these two distinct approaches have an impact on the procurement process while also having implications for actual financial results.
Considering the cost savings vs cost avoidance, the cost savings improve the current budget statement whereas cost avoidance ensures future budget stability but may not be reflected immediately in financial reports.
Сost reduction is often more impactful for SMB's with tighter budgets and a need for quick financial wins. Because it is easily recognized in the bottom line, cost reduction is a more practical and measurable strategy in such cases.
Whereas сost avoidance is more commonly leveraged by procurement-mature organizations that have advanced processes, strategic supplier relationships, and a long-term focus on value creation.
How to Maximize Cost Savings with Team Procure?
Our procurement management platform built for small and medium-sized businesses to automate purchasing, improve spend control and increase supplier transparency. By centralizing procurement workflows, it enables faster approvals, decision-making and more efficient spend tracking across projects and teams.
- RFQ: Team Procure streamlines the request-for-quotation process, allowing users to collect and compare multiple supplier bids quickly, leading to better pricing and reduced procurement costs.
- Budget Management: The platform provides real-time company budget tracking and approval controls, helping teams avoid overspending and stay aligned with financial targets.
- Spend Analysis: With detailed analytics and reporting tools, businesses can identify high-cost categories, monitor purchasing trends, and uncover new opportunities to reduce unnecessary expenses.
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Final Words
Understanding the difference between cost savings and cost avoidance is essential for building a more strategic, financially sound procurement function.
Cost savings provide reductions in spending and lead to measurable results immediately. On the contrary, cost avoidance is about preventing future costs. This is possible by getting long term agreements and making for acceptable contractual negotiations. Both strategies are essential for maintaining financial health over the years. Combining cost savings with cost avoidance provides a purchasing cost control strategy that affects both short- and long-term perspectives.
With the right tools and strategy, procurement teams find significant improvement in financial reporting and enhance cost management to have a much healthier bottom line. Team Procure provides the capabilities to achieve these results — schedule a demo to see how our platform can streamline your procurement process.
