Cost Savings

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Cost savings refers to the amount a company saves due to higher efficiency or better purchasing costs.

The finance team always measures cost savings as a reduction in the set budget. If the cost reduction doesn’t impact the budget, it can’t be considered cost savings.

Cost savings = Actual budget – final cost

The actual budget is the total budget set for that project.

For example, if you are negotiating the cost for a widget that the company will purchase over two years, the cost savings need to be adjusted against the two-year budget.

Let’s explain cost savings with an example:

Suppose you have an annual subscription to a CRM(Customer Relationship Management) tool. You already have a negotiated cost for one year, and the contract is up for renewal.

Now assume you have $1M in the budget for the next year.

This forecast considers the past usage history and any projected cost increases.

Now let’s say you could negotiate a better cost with the vendor because you agreed to a 3-year contract.

The new annual price is $800,000 annually for a total cost of $2.4M ($800,000 *3)

So using our formula, the cost savings for the first year = $1,0000 – $800,000 = $200,000

The cost savings is $200,000 for the first year, and the forecast is adjusted based on the new negotiated cost for the rest of the two years.

Let’s take another example:

Let’s use the same example of the CRM software where you have $1M in the next year’s budget.

In this case, let’s say the vendor comes with a price increase of $100,000. So instead of the subscription renewal at $1M, it is not $1.1M.

Let’s assume that by using your ninja negotiation techniques, you convinced the vendor to keep the cost same ($1M).

In this case, the savings can’t be considered cost savings. Let’s detail that in the next section.

What is not cost savings?

If the reduction in cost doesn’t positively impact the budget, it can’t be considered cost savings. In that case, it is considered cost avoidance.

For example, you have a budget of $1000 to purchase a laptop. You decided to go with higher specifications than what you had planned.

So the laptop quote is now for $1,500. Let’s say you were able to negotiate a better cost with the vendor, and instead of $1,500, the laptop now costs $1,200.

You saved $300 as compared to the original quote.

But compared to the Budget, you are $200 over budget ($1200- $1,000).

So even though you saved money, you are still over budget, so one can’t consider that as cost savings. Instead, it is called cost avoidance.

Sometimes professionals also use the word “soft savings” instead of cost avoidance.

Who is responsible for cost savings?

It depends upon the size and maturity of the company.

A procurement team is responsible for the cost savings initiatives in medium to large-sized companies.

In smaller companies, it is probably up to the operations team to review and negotiate vendor contracts.

If you have a procurement department, they generally have cost savings as one of their Key Performance Indicators (KPI).

The cost savings KPI is calculated based on the addressable spend. Addressable Spend is the spending with external vendors that the procurement department manages.

Suppose your total spend with vendors is $10M a year. Out of the $10M, $2M is pre-negotiated employee-related expenses. So the addressable Spend is $8M.

A procurement team generally has a KPI to achieve 6-8% of the annual addressable spend.

So if the addressable spend is $8M, the procurement team has a cost savings goal of $480,000 – $640,000.

These are just general guidelines, and the cost savings goal could vary drastically based on the nature of the Spend and whether the procurement team has negotiated the Spend in the past.