Fixed costs are those costs whose incurrence or quantum does not change with a change in business activities. They remain the same and must be incurred in full even if the activities to which they facilitate increase or decrease during the period. Fixed costs, in fact, are incurred even when activity level is zero.
Within fixed cost, there is however a further bifurcation – committed and discretionary fixed costs. This subcategorization of fixed cost is based on the necessity of incurring the costs and the ability of management to impact or modify them, especially in short run.
Committed fixed costs
As the name suggests, the committed fixed costs are those costs that a firm must incur during a specific period due to some past actions or commitments undertaken by its management. They thus cannot be avoided, especially in the near term, without significant adverse outcomes for the firm’s operations. These costs generally have some legal binding regarding their incurrence.
The unavoidable and critical nature of committed fixed costs necessitates management to set an accurate budget for them for each period.
Examples of committed fixed costs
(1). Annual Maintenance Charges (AMC) for factory machinery
Let’s say, a company has purchased a new machine to upgrade its manufacturing process. In addition, the company has simultaneously undertaken an AMC contract for its regular maintenance for a period of 5 years at an annual payment of $10,000. This cost classifies as a committed fixed cost since the company will have to incur it as the result of a contractual arrangement. In case the company does not incur this cost, it may have to face a serious disruption in its production activities. In fact, upkeep of the machine will be necessary even if the company has very limited or zero production activities during a period.
(2). Lease rent
A company has entered into a 10-year lease contract of annually $100,000 with a 5% escalation each year. This cost also qualifies as committed fixed cost because if the company does not pay this costs, it can be subject to legal consequences, and even disruption of its operations.
Discretionary fixed costs
Discretionary fixed costs are those fixed costs which although do not vary with level of output but can be altered or controlled to some extent by firm’s management. By nature, these costs can be modified for shorter periods without causing a severe impact on operations and/or profitability of the firm. From time to time, management can take appropriate decisions with regards to modification of these costs as per budgetary constraints.
Example of discretionary fixed costs:
Marketing and advertising expenses
Every quarter or every financial year, management can budget the amount they want to spend on marketing. If there are budget limitations in a given period, management can decide to cut back on these expenses. This is often possible without an immediate significant impact on operational activities and/or profits. Of course, like all other discretionary fixed costs, management should ideally cut back on these costs only for a limited time period. Continuously avoiding these costs may result in less brand visibility, limited turnover and squeezed profit margin.
Importance of classification
The identification of committed and discretionary fixed costs bears special importance for efficient budgeting. Management prepares periodic budgets which are usually further split into quarterly basis, four for each year. Generally, all departments in a company are individually given a specific budget to meet their expense needs. The heads in each department need to strictly consider all committed fixed costs but have the leeway to increase or decrease any discretionary fixed costs by their decisions. Thus, they can benefit from this cost bifurcation to limit or increase the total expenses within their department so as to fit into the overall budgetary framework.