Most Firms Ignore Cost Avoidance, Destroy Economic Value

I was thinking about a recent thread on a procurement-related LinkedIn group that featured some very “lively” discussion on the topic of cost avoidance vs. cost reduction. There were many people shouting at each other without really listening to each other, but it was funny because everybody thought THEIR definitions were correct, even though the collective discussion clearly demonstrated the plurality of opinions and complexity of the topic.

I love the topic of procurement performance measurement, and when I was at Hackett, we would absolutely, but lovingly, agonize over fine-tuning the detailed definitions for the most seemingly ‘basic’ of metrics such as cost savings and cost avoidance. For example, for cost reduction, what about when no baseline existed? What about the effect of volumes? How long of a period did savings get counted (e.g., one year vs. contract duration)? Is the figure net of unfavorable PPV? And on and on.

For cost avoidance, the scope of potential benefits that get lumped into this bucket or the other ‘soft savings’ (I hate the term ‘soft’ – it’s near meaningless) bucket is even more vast. But, traditional wisdom says that soft savings are bad and that cost avoidance should be avoided as a metric. Nothing could be further from the truth! This is true especially as procurement increasingly delivers value streams that are much more difficult to measure directly.

Cost avoidance gets a bad reputation for a few reasons. One is that it’s often defined narrowly like “it’s the amount of a supplier proposed price increase that we staved off.” Who was on the tribal rules committee that made this scenario the de facto definition? It’s obvious why Finance laughs at Procurement on this one. But a commercial airline CFO doesn’t laugh off the performance of the firm’s ‘hedge book’ – but yet that is cost avoidance too.

In fact, I’m going to just throw it out there…

Isn’t cost reduction really the same as cost avoidance? 

What?! I know this may sound like crazy talk, but hear me out. If you paid $10 for a widget, but then reduced it to $9, didn’t you merely avoid paying the old rate of $10?  I’m not just playing with words. Let me give you another example. If today you do a 1-year non-renewing contract on a $4 item that ends up going to $5 in 12 months when you write your next 1-year contract, you have an unfavorable PPV (i.e., a ‘negative cost reduction’) in year 2 of $1. But, if you did a 2-year contract at $4, you avoided that $1 increase. The only thing that differed here was your choice in contract duration, but depending on the choice, the result was either put in the cost reduction bucket (albeit in the wrong direction) or in the avoidance bucket.

But, the money that was gained/lost doesn’t care what bucket it’s in! So, why do we put ourselves into these self-imposed definition categories? You may argue that it’s Finance’s fault and they are to blame for such a narrow measurement system, but it’s Procurement’s job to illustrate the very real harm that such narrow performance measurement systems can have.

In the next part of this series, I will illustrate this concept with a story.

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