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COST EFFECTIVENESS VS COST EFFICIENCY: WHAT'S THE DIFFERENCE?

Updated: Nov 8, 2023

The terms “cost effective” and “cost efficient” are frequently used interchangeably in business, but it’s important that distinction is made between the two terms.

When companies are making decisions, it’s important to consider both cost effectiveness and cost efficiency. By considering both these factors, businesses can ensure that they are making the most cost-effective decisions possible, ensuring profits remain high even through times of turbulence.


Ready to learn more? In this guide, we’ll dig deeper into:

COST EFFECTIVE MEANING

Cost effective means achieving a desired outcome at the lowest possible cost. It is a measure of how well the resources used are aligned with the results achieved. A cost effective solution is one that achieves the desired outcome while using the least amount of money. Even when costs are high, a business can still be cost effective.


​​When it comes to SaaS businesses, a prime example of being cost effective is to outsource many of their non-core activities by way of reducing costs. This means delegating many of the key functions such as IT support, accounting, and customer service to service providers outside of the business. This strategy allows SaaS companies to focus their attention on the core activities, with the added benefit of reducing expenses when it comes to salaries and office space.

Why is cost effectiveness important?


Cost-effectiveness is an incredibly important methodology all businesses should consider. It allows companies to maximize profits while minimizing outgoings. It also provides an opportunity for firms to measure how successful they have been at achieving their goals through cost-effectiveness.

When you achieve cost-effectiveness, you’re making the right decisions for your organization, and this is the best way to achieve growth. If your target is growth, you should be employing cost-effective strategies and have them as a priority.


COST EFFICIENT MEANING


On the other hand, cost efficiency is a measure of how well the resources used are aligned with the results achieved. A cost-efficient solution is one that achieves the desired outcome while using the least amount of resources.


The key goal for the majority of companies is to significantly improve cost efficiency. This is not simple though because a company’s structure and its nature differs, so many organizations try other methods of becoming cost-efficient. Automation is a common strategy for many businesses as it enables them to cut costs while continuously improving processes. Automating many of the repetitive tasks is a significant time-saver and guarantees the quality set by the organization.


Why is cost efficiency important?


Cost efficiency is viewed as importantly as it is because it ensures your business is profitable and sustainable. If you have poor cost-efficiency, you will end up spending more money than you generate. A successful cost-efficient business reduces costs and increases your profit margin.

It’s worth noting that cost efficiency is not just a financial metric, as it is the connection between cost and quality, and it ensures your organization can continue to satisfy the needs of your customers. Without the quality factor in the equation, this will be a major stepping off point for your customers, leading to a revenue drop.


THE DIFFERENCE BETWEEN COST EFFECTIVE AND COST EFFICIENT


When you’re striving to be effective, it is about doing the right things. When it comes to being efficient, it is instead about doing things the right way. The optimal position for a business is to be both effective and efficient, whereby the right goals are pursued and the organization is being run in a cost-efficient manner. You get the best of both worlds, with a high return on your investment and costs are more efficient.


To help you visualize costs a bit better, let’s look at one example:


Let’s say you’re looking to buy a used car. You have $10,000 to play with and you want to purchase it outright. There may be offers of something more expensive and you may be encouraged to use the $10,000 as a down payment, but you don’t want the stress of a loan.


Car A is a newer model but has a higher mileage. Car B is older, with some minor scratches, but has a lower mileage and a more thorough service history. Car A costs about $1,000 more than its counterpart, and both have the same fuel efficiency.

The question is, which car do you buy?


Making this choice is not about the fuel efficiency or the actual price, but it is about the total cost of ownership. On paper, because car A is newer, you’d think it’s the sensible solution. Once you take a closer look however and realize it hasn’t been looked after as well, it’s harder to convince yourself that this is the better of the two.


Car B is $9,000 compared to car A’s $10,000, so the spare $1,000 can be used to pay for tax and insurance to ensure you don’t exceed the initial $10,000 budget. If you were to buy car A, you would pay the price tag “within your budget” but you will still have to contend with the extra costs so you can legally drive the car.


You can see in this short example that what appears effective isn’t always efficient. Both cars are within budget, but one will likely lead to pricey repair costs down the line, due to its higher mileage and lack of service records.


Business typically look to improve their operational efficiency. When you’re doing this with limited resources, it is wise to maximize the utilization of every resource at their disposal, from time and technology to budget. Some companies can shoot themselves in the foot by pursuing efficiency at all costs as they often miss the chance to take a step back and assess their overall effectiveness.


When organizations are chasing the right goals and doing it in an efficient way, they’re properly utilizing technology, minimizing time wasting, and have clearer and more effective collaboration between teams and departments. There are many businesses out there that have the right idea because they’re set on the goals they want to achieve, but a lot of them are inefficient when it comes to actually achieving them.


HOW TO APPLY COST EFFECTIVENESS AND COST EFFICIENCY IN BUSINESS


If you’re looking for ways to strike the balance between cost-effectiveness and cost-efficiency, employing a cost-benefit analysis can be a vital tool. It is a way to systematically review and analyze which decisions are worthwhile to make and which ones are not. A cost-benefit analysis summarizes the potential rewards that may result from an action and then subtracts the associated total costs of taking that action.

A big part of a cost-benefit analysis is measurable financial metrics such as revenue earned resulting from the decision to pursue a certain project. A cost-benefit analysis will also likely include intangible effects from the decision such as employee and customer satisfaction.


In essence, the cost-benefit analysis is useful for determining whether a project is financially feasible or if it is worth going down another avenue. The decision will also take into account the opportunity cost. The opportunity cost gives businesses an idea of any alternative benefits that may come when picking one alternative over the other. The opportunity cost is the missed potential benefits that would come as a result of a decision.


By taking serious consideration into all options and examining the likely missed opportunities, the cost-benefit analysis is more thorough and encourages better decision-making.


Project Margin in Precursive
Project Margin in Precursive

 

KEY TAKEAWAYS


If you couldn’t tell the difference between cost effectiveness and cost efficiency before this guide, then you should have a much better understanding of it now. Understanding cost efficiency can mean businesses have more visibility of their risks and potential outcomes, making them better equipped to make important decisions. Another tool that aids with decision making is a powerful PSA tool like Precursive. Our software can improve and automate a wide range of activities relating to professional services from resourcing, to time tracking and billing.


The best way to understand what Precursive can do for you is to see it for yourself. Book a demo today to see how we can help you improve cost effectiveness and cost efficiency.


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