An avoidable cost is an expense that can be eliminated or avoided if a specific business decision is made or a particular course of action is taken. Avoidable costs are not incurred if the associated activity is discontinued or altered. In contrast, unavoidable costs will be incurred regardless of the decision or action taken.
Avoidable costs are important in managerial decision-making, particularly when evaluating whether to continue or discontinue a product line, department, or project. By analyzing avoidable costs, management can determine if eliminating a specific activity or operation will lead to cost savings and better allocation of resources.
Examples of avoidable costs include:
- Direct labor and material costs associated with a specific product line that can be eliminated if the product line is discontinued.
- Overtime pay for employees working on a specific project that will no longer be needed if the project is canceled.
- Marketing expenses for promoting a particular service that can be avoided if the service is discontinued.
Note that avoidable costs should not be confused with sunk costs, which are costs that have already been incurred and cannot be recovered, regardless of the decision made.
Example of an Avoidable Cost
let’s consider a fictional company, ABC Manufacturing, which produces two product lines: Widgets and Gadgets. The management team is considering discontinuing the production of Widgets due to declining sales and profitability. They want to analyze the avoidable costs to determine if this decision will lead to cost savings.
Here are some of the avoidable costs associated with the Widgets product line:
- Direct labor costs: ABC Manufacturing employs 20 workers specifically for the production of Widgets, each earning $15 per hour. If the company discontinues the Widgets product line, these labor costs will be eliminated. Assume they work 40 hours per week for 50 weeks per year, the total direct labor cost for Widgets is $15 x 20 x 40 x 50 = $600,000.
- Direct materials costs: The Widgets production requires raw materials that cost $100,000 per year. If the production is stopped, the company will no longer need to purchase these materials.
- Marketing expenses: ABC Manufacturing spends $50,000 per year promoting the Widgets product line. If they discontinue Widgets, they can avoid these marketing costs.
In this example, the avoidable costs of discontinuing the Widgets product line are:
Total avoidable costs: $750,000
By analyzing these avoidable costs, the management team at ABC Manufacturing can determine whether discontinuing the Widgets product line will result in significant cost savings and make an informed decision about the future of the product line.