Understanding the cost classifications of avoidable and unavoidable costs is vital in order to make a number of business decisions. The key difference between avoidable and unavoidable cost is that avoidable cost is a cost that can be excluded due to stoppage of conducting a business activity whereas unavoidable cost is a cost that continues even if the activity is not performed.
CONTENTS
1. Overview and Key Difference
2. What is an Avoidable Cost
3. What is an Unavoidable Cost
4. Side by Side Comparison – Avoidable vs Unavoidable Cost
5. Summary
What is Avoidable Cost?
Avoidable cost is a cost that can be excluded due to stoppage of conducting a business activity. These costs are only incurred if the company decides to proceed with a certain business decision. Further, avoidable costs are direct in nature, i.e. they can be directly traced to the end product. Understanding such costs is advantageous to businesses since it assists in identifying the costs that do not contribute to profits; thus, they can be eliminated by discontinuing the nonprofit making operations.
E.g. JKL Company is a large-scale manufacturing company that produces 5 types of consumer products. Each product is completed in a separate production line and marketed and distributed separately. From the results for the past two years, JKL had been experiencing reducing sales from one product due to competitor actions. Thus, the management decided to discontinue the respective product; as such the production, marketing and distribution expenses will be avoided.
Variable cost and stepped fixed cost are the main types of avoidable costs.
Variable Cost
Variable cost changes with the level of output, as such is increased when a higher number of units are produced. Direct material cost, direct labor, and variable overheads are the types of variable costs. Thus, if the increase in output is avoided, the related costs will be avoidable.
Stepped Fixed Cost
Stepped fixed cost is a form of fixed cost that does not change within specific high and low activity level, but will change when the activity level is increased beyond a certain point.
E.g. PQR is a manufacturing company that operates at full capacity and does not have extra production capacity in its factory. The company receives a new order to supply 5,000 units for a customer. Thus, if the company decides to proceed with the above order, HIJ will have to rent out new production premises temporarily for a cost of $ 17,000.
What is an Unavoidable Cost?
Unavoidable costs are costs a company incurs irrespective of the operational decisions it makes. Unavoidable costs are fixed and indirect in nature, meaning they cannot be easily traceable to the end product.
Fixed Cost
These are the costs that can be altered based on the number of units produced. Examples of fixed costs include rent, lease rental, interest expense and depreciation expense.
E.g. DFE Company produces two different types of products, product A and product B, in the same factory. Factory rent expense is $15,550 per month. Due to a sudden decrease in demand, DFE decided to stop the production for product B. Irrespective of this decision, DFE still has to pay the rent of $15,550.
In the very short term, many costs are considered to be unavoidable since they are fixed in nature. For instance, if a customer order is due within two weeks’ time, even the costs such as direct material, direct labor and variable overhead costs for that specific order are unavoidable.
Figure 01: Variable and fixed cost are avoidable and unavoidable in nature
What is the difference between Avoidable and Unavoidable Cost?
Avoidable vs Unavoidable Cost |
|
| Avoidable cost is a cost that can be excluded due to stoppage of conducting a business activity. | Unavoidable cost is a cost that is continued to incur even if the activity is not performed. |
| Nature | |
| Avoidable costs are direct in nature. | Unavoidable costs are indirect in nature. |
| Level of Output | |
| Avoidable costs are affected by the level of output. | Unavoidable costs are not affected by the level of output. |
Summary – Avoidable vs Unavoidable Cost
The difference between avoidable and unavoidable cost principally depends on whether they will be increased or decreased based on the level of activity. Certain costs are avoidable while others are unavoidable based on decisions. By identifying and eliminating non value adding processes and discontinuing products that have limited demand assists companies to avoid unnecessary costs and progress towards higher profits.
Reference:
1. “Avoidable Cost.” Investopedia. N.p., 14 Nov. 2010. Web. 25 May 2017. <http://www.investopedia.com/terms/a/avoidable-cost.asp>.
2. Pettinger, Tejvan. “Avoidable Costs .” Economics Help. N.p., n.d. Web. 25 May 2017. <http://www.economicshelp.org/blog/glossary/avoidable-costs/>.
3. “Unavoidable Cost.” The Free Dictionary. Farlex, n.d. Web. 25 May 2017. <http://financial-dictionary.thefreedictionary.com/Unavoidable Cost>.
Image Courtesy:
1. “CVP-TC-FC-VC” By Nils R. Barth – Self-made in Inkscape.(Public Domain) via Commons Wikimedia