Cost savings analysis is a critical process for any business to ensure it uses resources efficiently and achieves maximum returns on investment.
Companies frequently encounter the dilemma of what decisions to pursue and which ones to forego. If you are unsure about a particular business decision, a cost savings analysis can provide invaluable insight into its financial and operational implications.
The method, also known as a “cost benefit analysis” (CBA), is just as crucial as a spend analysis, which evaluates procurement spend data to determine the best overall buying strategy. By determining the costs and benefits of a potential course of action, companies can decide where to invest their resources.
Read on to learn more about cost savings analysis and how it can help businesses improve their decision-making.
What Is Cost Savings Analysis?
Cost savings analysis is a process used to calculate both the direct and indirect costs associated with a potential course of action. It allows businesses to compare different options and determine which will provide the greatest return on investment.
By analyzing the short-term and long-term implications, companies can decide how best to allocate their resources. Ultimately, this helps them save money in both the short and long term and improve operational efficiency.
What Is Cost Savings?
Cost savings refers to the amount of money a company saves by making a particular decision. It is often measured as the difference in resources required to pursue the chosen option versus an alternative course of action.
When Do You Analyze Cost Savings?
Cost savings analysis can be used for various business decisions, from large-scale investments to smaller day-to-day tasks. Companies may conduct it when considering whether or not to purchase new equipment, hire additional staff, outsource certain services, and more.
In addition to making capital investments, cost savings analysis can also be done to identify areas of waste within existing processes. By analyzing the costs associated with each step in a workflow or process, you can pinpoint where you are spending too much money and improve efficiency accordingly.
Why Is Cost Savings Analysis Important?
A cost savings analysis provides a comprehensive view of the financial implications of any potential decision. But more than that, it offers several benefits in terms of efficiency and effectiveness.
Identify Areas of Opportunity
The first and most obvious benefit of cost savings analysis is that it provides visibility on spending, profitability, and efficiency. It can help you identify where your resources are being wasted or misused so you know what to focus on for future optimization efforts.
Take this for an example. A company may be able to save money by optimizing procurement operations, but it can only do so if it knows which areas need improvement.
Perhaps the company has been buying too much of a particular item, or it’s spending too much on shipping costs. A procurement analysis can help determine these areas and adjust accordingly.
Make Informed Decisions
Cost savings analysis helps organizations make more informed decisions by providing data-driven insights into the financial implications of their choices. When businesses explore the estimated costs for each option, they can better understand which course will be more beneficial in the long run.
The process also helps offset biases that can affect decision-making. By looking at the data objectively and analyzing it without personal judgment, organizations can make smarter moves.
By providing a comprehensive view of expected costs and total benefits, a cost savings analysis increases transparency and accountability within the organization.
Choosing data-based decisions rather than those based on gut feeling or intuition helps ensure everyone in the organization understands why a particular course of action was chosen. This increases trust between departments and encourages the team to think more critically.
Improve Operational Efficiency
As mentioned, cost savings analysis offers a comprehensive and balanced assessment of potential investments. Companies can use the results to decide which will best benefit their operations.
The process involves gathering data on all operational costs associated with a particular decision, such as labor, materials, and overhead expenses. Then, these costs are compared against expected benefits to determine whether the investment is likely to be profitable or not in the long run.
If the analysis reveals that an action is unlikely to generate sufficient returns, it may be better for businesses to pursue other options. Similarly, if the predicted benefits outweigh costs substantially enough in the long term, it might be more worthwhile to invest in that particular course of action.
Create a Performance Culture
A cost savings analysis helps create a performance culture that values data-driven decision-making. By evaluating the return on investment (ROI) of capital expenditures, you can determine which investments are sensible and which ones should be avoided.
The method is especially important when it comes to budgeting decisions. Companies must take into account both direct costs (such as materials and labor) and indirect costs (such as energy consumption). With CBA, businesses can compare different options to identify those with the most favorable ROI and allocate resources accordingly.
Moreover, cost savings analysis provides an opportunity to assess potential risks associated with certain investments before committing resources. Companies can use CBA to identify potential financial, operational, and reputational risks that could arise from a particular decision.
Types of Cost Benefit Analysis
Different methods of analysis can be used for cost savings. Let’s look at some of them in detail.
Net Present Value Method
NPV is the most popular method of cost savings analysis and involves calculating the present value of a future stream of cash flows. The calculation takes into account the time value of money, which means that money received in the future is worth less than money received today.
By subtracting out all costs associated with a project from its expected returns, companies can determine whether or not it will be profitable over a certain period of time based on current market conditions.
To get the NPV, you need to find the current value of future cash flows by using a discount rate equal to the minimum acceptable rate of return.
Benefit Cost Ratio
The benefit cost ratio (BCR) is another type of CBA that evaluates the expected returns from a project compared to its costs. The result is expressed as a ratio between benefits and costs, with higher ratios indicating more favorable projects.
This method requires companies to estimate the monetary value of tangible and intangible factors associated with each potential decision or course of action.
To calculate BCR, divide the total expected benefits by the total cost of a project. A ratio greater than 1 indicates that the associated costs are worth it, while a BCR lower than 1 suggests that the potential returns don’t justify the costs.
Incremental Benefit Cost Ratio
The incremental benefit cost ratio is a variation of the BCR method that compares two or more options with each other. It evaluates which option will provide the most value for money.
This analysis is useful when companies are looking at different suppliers, processes, or products and need to choose between them.
To calculate the incremental benefit cost ratio, take two projects and subtract the discounted benefits for each. Then divide the result by the difference in the total discounted costs for each project.
How Do You Analyze Cost Savings?
A cost benefit analysis process involves a systematic approach to assess the costs and benefits of a particular decision. These are the primary steps to take:
1. Define the framework
The first step in conducting a cost savings analysis is establishing a framework. Here, it’s important to outline the proposal in detail, including the goals, objectives, and expected outcomes.
Then, decide on the metrics that will be used to measure the results. This could include cost savings, revenue growth, and other key performance indicators (KPIs). You will need to measure costs and benefits in a common currency so the results can be accurately compared.
The framework may include these components:
- The type of decision being evaluated
- Goals and objectives of the decision or project
- Metrics in measuring the cost and benefits
- The timeframe for the analysis
- The sources of information used in the process
- Potential implications and risks associated with the decision
Once these elements are determined, you can develop an appropriate methodology that fits within your overall business strategy while taking into account factors like budget constraints and market conditions.
2. Identify all associated costs
The next step to analyzing cost savings is determining all the costs associated with a particular course of action. These costs include:
- Direct costs. These are the costs that can be directly attributed to a decision. They include labor, materials, supplies, and other direct expenditures necessary.
- Indirect costs. These are the costs associated with decisions but not necessarily related to them. For example, administrative overhead or long-term maintenance expenses may be considered indirect costs since they don’t directly contribute to the implementation of a decision.
- Intangible costs. These costs are harder to quantify but can still be considered when analyzing cost savings. They include customer satisfaction, employee morale, or other factors that may affect the financial performance of a business.
- Opportunity costs. These costs are the benefits that could have been gained if a different decision had been made. For example, if you decide to invest in new technology instead of expanding your marketing efforts, the opportunity cost is the potential returns from increased sales due to more effective advertising.
- Risk costs: These refer to costs associated with potential risks associated with a decision. They include insurance, legal costs, or other expenses related to minimizing risk.
Remember to assign a dollar value to each cost to ensure accurate comparisons. For costs that are harder to quantify, you can involve subject matter experts (like HR managers) to assign a reasonable value.
3. List the total benefits
After categorizing the costs, the next step is to list the total possible benefits of a decision. To help you identify them, consider the following:
- Direct benefits. These are the benefits that can be directly attributed to a decision. They include increased revenue, improved customer satisfaction, cost savings, and other measurable outcomes.
- Indirect benefits. These benefits can be attributed to a decision but are not necessarily related to it. They may include tax savings, increased efficiency, or other long-term impacts.
- Intangible benefits. These are hard to quantify but should still be taken into consideration. They can include increased team morale, improved employee satisfaction, and other benefits that cannot be captured in a spreadsheet but still have value.
- Competitive benefits. These are the benefits a decision might bring to your competitors, such as improved market share or better customer service.
As with costs, don’t forget to assign a dollar value to each potential benefit. Quantifying all of them will make it easier for decision-makers to evaluate the pros and cons of each option.
4. Determine the discount rate
The discount rate is an interest rate used to calculate the present value of future costs and benefits. It is the amount of the time-value of money that must be subtracted from future cash flows to reflect that money today has more value than money at some point in the future.
The discount rate allows companies to compare costs and benefits across different periods, so they can identify which decisions are most profitable over time.
5. Calculate the costs and benefits
Once you have identified the costs and benefits, use them to calculate the total cost savings that a decision might bring. Start by subtracting all of the associated costs from the total potential benefit. The difference will give you an estimate of how much money a particular decision could save or generate over time.
For example, if your analysis shows that a certain decision would cost $150,000 but deliver $200,000 in benefits over five years, it would have generated a net savings of $50,000 ($200,000 – $150,000).
This is just a general approach. You may refer to the various types of cost benefit analysis available (see above section) to produce relevant results.
6. Conduct sensitivity analysis
A sensitivity analysis is a way of testing how changes in the input variables may affect the outcome of a decision. It can help you determine what risks and opportunities are associated with each option and whether they are acceptable or not.
For example, if you’re looking at implementing a new software system, you might want to analyze how changes in labor costs or user adoption rates would affect your overall cost savings. This could provide valuable insights into which decisions should be pursued or avoided.
Get Started with Your Cost Savings Analysis
The cost savings analysis process can seem intimidating at first. It requires a great deal of research, data collection, and analysis. But once you break it down into smaller steps, the process becomes much more manageable.
Since conducting CBA can lead to smarter decisions, it’s important to get it right. Tipalti Approve can help you get started on the right foot by providing a comprehensive set of tools to automate the process.