Table of Contents

Avoidable Cost: Strategies and Real World Examples

By

Updated June 12, 2021

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.

Key Takeaways

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 may strive to move as many costs as they can to become avoidable costs, which allows them more flexibility in times of financial distress.
However, businesses may also strive to move as many costs as they can to become fixed (and usually unavoidable); this allows the company to leverage economies of scale and potentially yield higher profit.

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. In this situation, any product line that is discontinued would no longer incur the expense of the raw materials, labor costs, or overhead charges.

Corporations looking for methods to reduce or eliminate expenses often analyze avoidable costs associated with underperforming or non-profitable product lines. Fixed costs 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. Therefore, "avoidable cost" not only refers to the item being purchased but the timeframe in which it is being purchased.

Avoidable costs are internal accounting measurements only. Companies will not externally report their avoidable costs as part of their financial statements.

Avoidable Cost Strategy

For many companies, it is in the best interest 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.

By doing so, the company can reduce its operating risk and know it can avoid expenses if it needs to. 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.

On the other hand, it may actually be advantageous for a company to enter into certain types of contracts that result in unavoidable costs. Consider an example where a manufacturer can either pay $5 of raw materials for each unit it wants to produce or a fixed $1,000 per month for all raw materials. If the company chooses the $5 option, its unit cost will always be $5. However, should the company decide to manufacture 250 units and opt for the $1,000 fixed (unavoidable) cost, its unit cost would only be $4.

The example above is an example of financial leverage. By committing to a fixed, unavoidable cost, the company incurs risk that it may fail to bring in enough sales or revenue to cover the cost. Alternatively, should the company's business thrive, it will reap larger profits than it would have had it opted for an avoidable contract.

For most, every trip to the grocery store results in unavoidable costs (i.e. daily essentials) and avoidable costs (i.e. ice cream isn't technically a necessity).

Example of Avoidable Cost

Avoidable and unavoidable costs are never explicitly called out within a company's financial statements. However, certain notes to the financial statements usually indicate certain types of costs that exemplify what type of expense is being reported.

Consider Apple's 2021 annual report where the company reported spending $21.9 billion on research and development. Some may have the strong argument that this is an unavoidable cost; in order for Apple to maintain its position as an industry leader, it must be on the forefront of technical innovation.

As part of the notes to its financial statements, Apple states it "continues to believe that focused investments in research and development are critical to its future growth". The opposing argument could be made that this type of spend is avoidable; it is not necessary for business operations today and there is no guarantee that this spending will deliver any future benefit to the company. In some regards, this R&D spend may be seen by some as avoidable.

On the other hand, the company later discusses manufacturing purchase obligations as well as other purchase obligations. When discussing manufacturing purchase obligations, the company notes that the agreements are primarily noncancelable. Even if Apple were to never manufacture a single product ever again, it would likely still be contractually obligated to pay these charges. This type of expense is an example of an unavoidable charge.

Apple, Select Notes to Financial Statements (2021).

Is It Better to Have Avoidable Costs or Unavoidable Costs?

It depends. For many companies, avoidable costs offer less risk and greater flexibility as the company can choose to not incur the expense if it doesn't want to (or financially is unable to). However, unavoidable costs like fixed-term contracts may be beneficial for companies looking to scale operations. Instead of locking into a per-unit cost, companies can incur unavoidable lump-sum agreements that may turn out to be advantageous depending on their level of production.

How Can I Tell if a Cost is Avoidable?

A cost is avoidable if there is no fixed contract requiring the company to incur the charge. In addition, avoidable costs often move in tandem with operations. Should a cost be incurred as the result of a company wanting to manufacture one additional unit, more often than not that expense is avoidable.

Where Are Avoidable Costs Reported on Financial Statements?

Avoidable costs are not explicitly broken out on a company's financial statements. Instead, the company may include certain statements within the notes to their financial statements that indicate whether the company might be able to avoid certain costs. Companies are not obligated to report avoidable costs externally, and avoidable costs are usually only reported internally for strategic purposes.

Are Sunk Costs an Example of Avoidable Costs?

No, sunk costs are expenses that have already been incurred that should not factor into future decision-making. Because these costs have already happened, a company cannot avoid them. Still, the company should disregard sunk costs when making analytical decisions as the expense has already been incurred.

The Bottom Line

Companies that want to reduce risk and increase flexibility would be suited to perform an avoidable cost study. Avoidable costs are the expenses the company can easily forego; should the economy take a turn or business start to not be as strong, the company can simply choose not to incur the cost. This type of expense is opposite of an unavoidable cost, often a fixed cost that the company must pay no matter what.

Open a New Bank Account

×

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.