Fixed costs are those costs that are incurred by a business irrespective of its level of activity or output. In other words, fixed costs are incurred at a fixed specific amount even if the business has no activity for a given period and also they remain the same even if there is an increase or decrease in the level of activity. An example of this is rental cost. If a company acquires a building on rent to open an outlet in it, it would have to pay fixed rental cost irrespective of the volume of sales achieved by the outlet.
Within fixed costs there are two sub types of costs – committed and discretionary fixed costs. The article “committed vs discretionary fixed costs” looks at meaning of and difference between these two types of fixed costs.
Definitions and meanings
Committed fixed costs
Committed fixed costs are those fixed costs which are incurred due to certain past commitments of the entity. Management commits to undertake these costs for a specified time period. These costs must be incurred to keep business operations functional, making them necessary and unavoidable.
While preparing budgets and undertaking costing for its products, these costs must be included at their committed values as they cannot be avoided or eliminated. Non-payment of committed costs can have significant impact as it can result in disruption of business activities. It can also result in legal consequences if contractual costs and obligations are not met.
Examples of committed fixed costs:
- Machinery related costs: If a business has decided to purchase a machinery for a new line of products, the depreciation that would be charged on that machinery is mandatory and is, therefore, a committed fixed cost.
- Lease rentals: A service industry entity has entered into a lease contract for office space for period of 5 years. The lease rental expense has thus been committed to be undertaken by the management for this period and must be incurred if office operations are to continue.
Discretionary fixed costs
Discretionary fixed costs, as the name suggests, are those fixed costs which are incurred at the discretion of entity’s management. These costs can be reduced or modified without significant impact on the short-term day to day operations of the entity.
The nature and amount of these costs to be incurred are decided by the management each year whilst budgeting, based on availability of surplus funds and cost benefit analysis.
Examples of discretionary fixed costs:
These costs have the potential to provide value addition to the entity; for example, advertising can potentially increase sales and revenues, employee training can reduce wastage, improve resource utilization and increase productivity etc. Thus, while these costs can be eliminated in the short run at the discretion of management, eliminating them over a longer term can negatively impact the entity and its profitability.
Difference between committed and discretionary fixed costs
The main points of difference between committed and discretionary fixed costs have been given below:
- Committed fixed costs are those costs which are fixed obligations of the business and must be incurred to maintain continuity of operations.
- Discretionary fixed costs are those costs which are optional to the extent that their incurrence and value is determined by budgeting exercise of the management.
2. Arise from
- Committed fixed costs arise from past events or past decisions of the management. For example, committed costs with respect to plant and machinery are determined at the time of determination of production capacity by the management.
- Discretionary fixed costs arise from year on year budgetary decisions of the management. For example, management will allocate a research and development budget each year towards innovating new products or modifying the existing ones.
3. Time frame
- Management commitment to incur committed costs are undertaken for a longer time period.
- Management decision with regard to discretionary costs are for a shorter time period – usually one year or less.
4. Subject to cost control
- Once management decision has been taken to incur certain committed costs, they can no longer be controlled, at least within the short term. This means once committed these costs usually cannot be reduced or eliminated.
- Management does not give any firm commitment to incur discretionary costs, they can thus be controlled even within a short term. For example, management can allocate a certain amount towards employee training in a budget but can keep amending this amount as the year progresses depending on the performance of the entity.
5. Impact on business operations
- Committed costs must be incurred to keep business functional. For example, if the entity stops paying rent of its factory premises it would not be able to manufacture its products and its business operations could cease.
- Discretionary costs are with respect to certain value-add activities and their non-incurrence need not hamper day to day routine operations of the entity, especially within the short term.
6. Correlation between expense and output levels
- Committed costs have a clearer relationship with output levels as these expenses must be incurred to maintain output levels.
- Discretionary costs may not have a clear, identifiable relationship with output levels. For example, it may be difficult to gauge the exact impact of advertising cost on sales achieved.
7. Impact of non-payment
- Non-payment of committed costs can disrupt normal functioning of the business itself. It can sometime also have legal consequences for the entity if contractual costs are not paid in time.
- Non-payment of discretionary costs would not disrupt operations immediately, but can impact profitability or efficiency over a longer term.
- Examples of committed fixed costs include depreciation of machinery, insurance of premises and machinery, rental of premises, maintenance costs etc.
- Examples of discretionary fixed costs include advertising costs, public relations expenses, employee training and development costs etc.
Conclusion – committed vs discretionary fixed costs:
Budgeting is an important management function. The identification of costs as committed and discretionary is important as it impacts budgeting. Discretionary costs play a larger role in year on year budgeting and decision making.
Although a one-time exercise, decision with respect to committed costs is a significant responsibility of management. Once incurred, they become obligatory for years to come.