Recently, I was engaged in a spirited conversation with a colleague regarding the real value of a cost avoidance strategy in a large company. His assertion is that cost avoidance would get you fired because the business leaders only care about cost savings. I’m looking for a more balanced approach. I understand the concept of cost savings, but it makes me think – is there no value in cost avoidance? Even more questions start to come to mind:
- What happens if we only focus on cost savings year after year?
- Are managers incented to budget for more and then ‘sandbag’ to show cost savings?
- What’s the real story here? Why is everything so relative and interpreted in so many ways?
- How does this approach line up with culture?
- Does it impose a culture-add or culture-fit environment? Cause vs. effect?
An organization, much like your own body, is made up of parts that need to work together. You emphasize certain aspects of your organization to achieve specific goals. If you want to be a world-class runner, you need to emphasize running in your workouts. A boxer? The muscles needed to box should be emphasized. A swimmer? Less running and more swimming, right? But much like a runner, a boxer or a swimmer, you should not just emphasize one thing or you’ll risk injury. We can view injury much like a quality issue in an organization – it may not kill you, but it can sidetrack your otherwise hold you back from your peak performance. Even Tiger Woods figured out that he needed more than just golf to succeed – he was an avid weight lifter in addition to his golf practice.
There are three types of costs we’re talking about:
- Cost-Savings
- Cost-Avoidance
- Opportunity Costs
Looked at another way, it is kind of a past, present and future look at your costs.
How do I see the problem? I view cost avoidance as an efficiency gain and as a way to strengthen other complimentary areas of your business. Efficiency in economic terms as described by Investopedia, “Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency.” http://www.investopedia.com/terms/e/economic_efficiency.asp . When was the last time we ever saw perfect efficiency in any organization? I never have. I’ve seen waste in all kinds of environments and processes. I’m paid to see that kind of waste and sometimes to address it.
Ok, so what is cost-savings in comparison? Cost savings refers to a cost already incurred vs. one that you avoided.
https://www.business-case-analysis.com/avoided-cost.html basically states that all the costs are related and relative.
In my experience, that’s accurate.
Does that approach scale in a multi-national, extra-large organization? Or does that only apply in a small business where everyone knows what everyone else is doing and can complement those actions? What’s the right approach?
That depends on what your goal is. If your goal is organic growth in a least-cost sustainable way, you need balance. If you intend to grow via acquisition methods, maybe you want to run your business units like small businesses that don’t share anything other than a name and tax number.
Focusing only on cost-saving is short-sighted and leads to huge and expensive quality issues later. Sometimes that is really important, especially if you’re a very small organization with very little cash flow.
But consider this: if we only focus on cost savings in year 1, we would necessarily cut costs. Sounds good right? But in practice most people will cut costs by looking at it through the lens of what they can absolutely do as the bare minimum for their job. They will limp along focused on cost ONLY and will miss the opportunity benefits that can come with healthy growth. They are no longer focused on healthy growth, but rather on cost savings. Now in year 2, the same thing happens. Your focus is on cost savings and no longer on growth. Year 3 comes along and you are running an emaciated organization. For 3 years in a row you cut costs and never invested in quality and expansion. I’ve seen this happen to the point of failure (injury) in several organizations. It’s usually looked at as the problem with IT – you have 70% of your budget spent on maintenance before you even finish your budget. It’s hard to innovate.
If this was your body and you focused on only cost-saving (think caloric intake), your short term gains would be to slim down. Goal achieved, right? That’s cost saving. But the long-term effect would be to fatten up the next time you had the access to additional calories. That’s quality issues. The same happens in business when you myopically focus on just cost savings. You enter into a see-saw of benefit and low-quality and then trying to fix the problem. Rinse. Repeat. As a side note, the diet business is a multi-billion dollar business for a reason. A lot of people want short term gains over long term discipline. They pay well for that convenience.
See what’s missing? The business leaders cannot see (nor should be expected to be able to see) how their choices impact the broader business and it stifles innovation. So they cut year after year until they move to another line of business and do the same thing. Meanwhile, that line of business they came from is sold or otherwise shuttered because they no longer are profitable and the business misses out on Opportunity Costs.
What does it all mean? It means balance in business is important. There are times that cost-savings are the absolute right answer. There are times when you must become more efficient and emphasize cost-avoidance. And never take your eye off the Opportunity Costs and benefits it may bring.
Al Mulnick's Personal Blog 