Definition
Avoidable cost is a business expense that can be eliminated or avoided if a specific activity or decision is no longer conducted or implemented. It is directly associated with or caused by a business decision, like manufacturing a product or offering a service. This cost does not occur if the activity or decision ceases to happen.
Key Takeaways
- Avoidable cost refers to expenses that can be eliminated if a certain business decision is not pursued. These costs differ from sunk costs which cannot be recovered if a decision is abandoned.
- Avoidable costs are typically variable costs that alter with the business’s level of output, and closely help in decision-making processes, such as whether to discontinue a product line or make decisions on outsourcing.
- A well-executed analysis of avoidable costs can greatly improve business efficiency by identifying areas for potential cost savings and allowing managers to focus resources more effectively.
Importance
Avoidable Cost is a crucial finance term because it is particularly relevant in decision-making processes related to cost management and optimization.
Essentially, avoidable costs are expenses that can be eliminated if a particular department, activity, or product line is discontinued.
Understanding which costs are avoidable allows businesses to make informed decisions about discontinuing unprofitable operations or eliminating unnecessary expenses.
It also provides a clearer understanding of the financial implications of various operational decision scenarios, offering critical insights that support cost-effective and profit-maximizing decisions.
Explanation
Avoidable cost refers to an expense that can be eliminated if a particular decision is made or action is taken. For instance, if a company decides to discontinue a product line, the related materials and labor costs become avoidable. This type of cost is crucial when considering alternative business strategies, as it assists decision-makers in determining the financial impact of their choices.
It could be directed towards investment or better allocation of resources which could eventually maximize profits. The central purpose of an avoidable cost is to provide insights into areas of business operations that can be adjusted or entirely discontinued to improve profitability. It allows organizations to determine the feasibility of a product or service by assessing whether its benefits outweigh its costs.
If the costs are higher, a business might reconsider its decision to continue offering such a product or service. Moreover, the concept of avoidable costs is widely used in cost accounting and is often the base for cost-benefit analyses, crucial for the successful management of any business. It allows for understanding the value of resources and promotes efficient resources allocation.
Examples of Avoidable Cost
Avoidable Cost is a cost that can be eliminated entirely, if a particular activity related to that cost is abandoned. It’s a management accounting concept, mostly used in decisions regarding whether to stop or continue operation in parts of a business. Here are three real-world examples:
Company A has been producing a certain type of widget as part of their product offering. However, the widget has not been selling well and it’s causing the company losses. The cost of producing this widget including raw materials, labor, and specific marketing expenses are avoidable costs because they can be eliminated if the company stop the production of this widget.
In a clothing retail business, let’s say a certain line of clothing (e.g., winter jackets) is underperforming and not generating enough sales. The costs related to this line such as buying the inventory from the manufacturer, storing the jackets in a warehouse, marketing costs for this line, and labor costs for sales staff dedicated to this line can be considered as avoidable costs, as these costs can be eliminated if the business decides to discontinue the winter jacket line.
A hotel has a restaurant that operates independently from the hotel. An evaluation shows that the restaurant has been running at a loss for the past two years. The costs related to running the restaurant: rent, salaries of employees, food supplies, equipment maintenance, and advertising costs, are all considered avoidable costs. If the hotel management decides to shut down the restaurant, all these costs can be avoided.
FAQs on Avoidable Cost
1. What is an Avoidable Cost?
Avoidable Costs are the expenses that can be eliminated if there is a particular path of action is discontinued. These costs include direct material costs, direct labor costs, and direct overhead costs.
2. What is the significance of Avoidable Cost?
The concept of an Avoidable Cost is significant in the decision-making process. If the Avoidable Cost of discontinuing a product, service or department is more than the associated revenue, it may be prudent to discontinue the operation. On the other hand, if the avoidable cost is less than the revenue generated, then the operation is profitable and therefore worthwhile.
3. Is Avoidable Cost the same as Opportunity Cost?
No, avoidable cost and opportunity cost are not the same but they are both essential considerations in decision-making processes. Avoidable cost is the cost that can be eliminated, while opportunity cost refers to the potential benefit that is given up in order to pursue a particular course of action.
4. Can all costs be avoidable?
No, not all costs are avoidable. Costs are primarily categorized into avoidable and unavoidable costs. Unavoidable costs are those that will be incurred regardless of the decision made or path chosen.
5. How can I calculate avoidable costs?
In order to calculate avoidable costs, you would need to consider the direct costs associated with producing a product or service. These may include labor costs, commodity costs, and direct overheads. Identifying these costs will help you understand the potential savings made by eliminating the product or service.
Related Entrepreneurship Terms
- Opportunity Cost
- Fixed Cost
- Variable Cost
- Sunk Cost
- Relevant Cost
Sources for More Information
- Investopedia: A comprehensive resource for investing and personal finance education.
- Accounting Tools: A site offering a wide range of information on accounting and finance.
- Coursera: Coursera partners with universities and organizations around the world to provide online courses, including topics in finance.
- Economics Help: This site provides simple explanations for complex economic issues and concepts, including various costs and finance topics.
