What Is an Avoidable Cost?
An avoidable cost is an expense that will not be incurred if a particular activity is not performed. Avoidable costs refer primarily to variable costs that can be removed from a business operation, unlike most fixed costs, which must be paid regardless of the activity level of a company. There are instances in which fixed costs can be avoidable costs.
- An avoidable cost is a business expense that can be eliminated by no longer undertaking the specific business activity.
- In most cases, but not all, avoidable costs apply to variable costs rather than fixed costs.
- A company with multiple product lines can exit underperforming ones, thereby removing the costs associated with them.
- Businesses should strive to move as many costs as they can to become avoidable costs, which allows them more flexibility in times of financial distress.
Understanding an Avoidable Cost
Avoidable costs are expenses that can be eliminated if a decision is made to alter the course of a project or business. For example, a manufacturer with many product lines can drop one of the lines, thereby taking away associated expenses such as labor and materials.
Corporations looking for methods to reduce or eliminate expenses often analyze avoidable costs associated with underperforming or non-profitable product lines. Fixed costs, such as overhead, are generally not preventable because they must be incurred whether a company sells one unit or a thousand units. However, if a specific business line utilizes a factory to make goods and that business line is discontinued, the factory can then stop being rented or can be sold.
In reality, variable costs are not entirely avoidable in a short timeframe. This is because the company may still be under contract with workers for direct labor or with a supplier for direct materials. When these agreements expire, the company will be free to drop the costs.
Avoidable Cost Strategy
It is in the best interest of all companies to have a cost strategy whereby the majority of the costs are avoidable. Businesses should often conduct a cost analysis of the company and determine how to transfer unavoidable costs to avoidable costs.
The benefit is that in times of financial distress or during economic downturns, a business can adapt and maneuver quickly by shedding avoidable costs. This might require streamlining product groups, improving efficiency, negotiating shorter-term leases on buildings, or shorter term-leases with suppliers.
Real World Examples
Even though fixed cost items, like building rent, utilities, insurance, and certain administrative salaries still had to be paid despite a reduction in the product count, there were significant avoidable costs associated with those products, such as marketing and sales expenses and research and development (R&D) expenses, that P&G was able to remove from its operations.
General Electric (GE) is another company that reevaluated its product offerings. GE is one of the largest companies in the world and has multiple product lines. It is known for its airplane engine business, lighting products, kitchen appliances, and more. During the economic downturn in early 2020, which impacted travel, GE's most profitable business, its airplane engine business was hit hard.
Airline manufacturers, such as Boeing, experienced a drop in demand for new airplanes as airplane companies saw a dramatic drop in travel demand. As such, Boeing (BA) did not need airplane engines, which impacted GE. In 2019, 33% of GE's revenues came from aviation, 20% from healthcare, 18.6% from power, and 15% from renewable energy.
As GE was struggling it decided to sell its 130-year-old consumer lighting business to Savant Systems. It previously sold its commercial lighting business in 2018. This allowed GE to focus on its most profitable divisions while shedding underperforming ones to free up capital by cutting costs and reducing debt. While deciding to sell this business, GE turned all of the costs associated with the division to avoidable costs.
In any industry where price competition drives down profit margins, companies attempt to identify as many avoidable costs as possible to improve their bottom line, streamlining their business to focus on its core goods and services.