Discretionary vs. Committed Fixed Costs
When you run a small business, you’re often tasked with doing it all. From finances to human resources to marketing, you likely wear many hats. This can be challenging when you don’t have specific experience in these areas. Fortunately, many financial tasks can be self-taught with the help of resources found online or via local small business councils. One of the most essential of these tasks is setting a budget and determining discretionary and committed fixed costs.
Budgeting is one critical aspect of running a small business. In order to qualify for a loan or gain approval from a board of directors, you'll likely need a budget and a business plan. The plan serves as the financial road map for your company in the years to come. Even if you are self-employed as a sole proprietor, design a business plan so you have a good idea of where your money will go in the future. You may also need a business plan if you file for certain legal business designations, such as a corporation requiring a board of directors or for insurance purposes.
Most business plans contain costs that you can control and costs that you can’t. These expenses are known as discretionary fixed costs and committed fixed costs, respectively. In many ways, these are similar to the wants and needs you may be familiar with in your own personal budget. However, both are considered fixed to a certain extent, while your personal wants, like going to the movies, are much more flexible. A good sense for which items in your business' budget are fixed and which can be changed will help to determine the profitability of your business plan.
A discretionary fixed cost is one that is a required expenditure for only a specific period of time or an asset that is occasionally an unnecessary expense, but a necessity at other times. In most cases, discretionary fixed costs can be eliminated or reduced more easily than committed fixed costs. Also, they have less of an impact on the profitability of a company if they are cut or reduced.
Costs that fall into this category are not ones that can be permanently eliminated. Instead, they are usually expenses that are temporarily reduced or set aside to help with the short-term bottom line. Over time, however, eliminating discretionary fixed costs can hurt your business in a variety of ways, ranging from reduced brand exposure to undertrained employees to reduced research and development outputs. Your company should always leave room in the budget for discretionary fixed expenses for this reason.
Committed fixed costs are those expenses that you cannot simply eliminate from your budget. They are expenditures that are necessary, since you need the goods or services these costs support in order to run the business. For instance, a company producing T-shirts needs a factory and fabric before it can begin to produce any shirts. A business that provides any kind of service usually needs an office in order to enable client meetings and a place for employees to work.
The period of commitment for committed fixed costs tends to be much longer than for discretionary expenses. For instance, the lease on your office building is most likely one that will be valid for a number of years. A decision to terminate agreements of this nature often lead to the loss of income due to penalties. It’s often the case that even if you wanted to eliminate expenses in this category, it might not be financially feasible to do so.
Additionally, the very nature of your business will likely make it difficult to alter your committed fixed costs once they are established. If you produce goods or provide services in a given location, you typically cannot just close up shop and relocate without suffering a significant financial loss. A restaurant, for example, must be located in a facility with a commercial kitchen and a dining space in order to operate legally. Relocation would require a business to stop and then restart again once a new facility was found.
Due to the difficulties involved with changing any aspect of committed fixed costs, it’s best to consider these decisions carefully. Consultation with lawyers, financial advisors, boards of directors and area chambers of commerce is wise before making long-term commitments.
Since discretionary fixed costs are defined as those that ebb and flow over long periods of time, they can vary widely based on the type of business you operate. Some common types of expenses that fall into this category include advertising campaigns, staff training, investor relations, public relations and research, quality control, maintenance and business development efforts. Other examples of committed fixed costs include website maintenance fees, insurance costs, payment of business loans or installment payments on any sort of business assets.
As you can imagine, cutting back in the short-term on advertising campaigns might have very little impact on your profit margins. However, if you were to completely cut out your advertising budget, your company would likely see reduced margins over time. Similarly, temporarily reducing funds set aside for quality control could be a fine choice for a shorter period of time. In a longer-term financial plan, though, elimination of any quality control processes would almost certainly have a detrimental effect on the reputation of your business and ultimately on profits.
Since committed fixed costs are those that cannot be eliminated from a company’s bottom line, they are often larger-ticket items. These can include the lease on office space, the purchase of a machine required for the operation of your business or utility payments. All of these expenses are necessary to the continued function of operations, and therefore cannot be eliminated. In most cases, it is also not possible to reduce these costs in any meaningful way.
When considering fixed costs, it’s important to include any additional fees or charges that will ultimately come as a result of your initial purchase. For instance, if you purchase an office building for $100,000, but have to pay a monthly maintenance fee of $250 to the executive park, you need to include the latter expense as part of the committed fixed cost budget, as well. Similarly, if your restaurant opens in a new location, the commercial liability insurance you will need for that physical storefront should be assumed as a fixed cost. All associated expenses that could arise as a result of a fixed cost need to be taken into consideration.
Though there are some similarities between committed fixed costs and sunk costs, the terms are not interchangeable. (Note that a sunk cost can also be referred to as a stranded cost.) Whereas a committed fixed cost is one that can’t be eliminated from your budget and still enable you to run your business, a sunk cost is one that cannot be recovered in any way whatsoever once it is paid for.
An example of a sunk cost is an advertising campaign for a new service. Say, for example, that your company’s leadership thought that a proposed offering showed immense promise, and $50,000 was allocated to advertising to target clients. However, once the campaign was completed, there was no movement from new or current clients to adopt the service. The sales team was unable to convince customers to sign on, and the service was therefore scrapped from the offerings list. Due to its failed launch, the $50,000 spent on advertising would be considered a sunk cost. The money in this example had been spent and could not be recovered.
In contrast, a committed fixed cost would be if you had proposed the same new service and many clients were interested; the sales team was able to arrange numerous signed contracts based upon the new service. In order to provide the promised deliverables, however, a $50,000 piece of machinery must be purchased. In this instance, the machine would be considered a committed fixed cost, because your company absolutely must have it in order to continue doing business it has committed to.
If your company’s financial software offers you the opportunity to distinguish discretionary and committed fixed costs, this is a great way to separate the two and keep your budget on track. If you don't use a program with this capability, you may be able to set up a separate budget category of your own that is used solely for discretionary costs. Consider past spending in each category when creating a new budget. Look for areas where you can cut back on discretionary costs, but be realistic. Budget an amount that permits some wiggle room going forward. Never budget exactly what you’ve spent in the past, as this can lead to forced reductions in discretionary expenses down the line if necessary funds simply aren’t available. Over time, these cuts can hurt your business.
When it comes to committed fixed costs, budgeting can be a bit easier. You already know how much money you will spend in certain categories each month because that’s the nature of such a financial commitment. Still, include a bit of money above and beyond the fixed costs as a just-in-case scenario.
Be sure to document every single expense you have, no matter how small. This is the only way to ensure accuracy in future budgeting and business plan updates. You’ll need to know how much to allocate for discretionary fixed and committed fixed expenses, so categorize what you spend now for an easier time in the future. Keeping your committed fixed costs as low as possible and steering clear of any unnecessary discretionary fixed costs is a sure way to keep your expenditures low and your budget on track.
When creating a budget or business plan, it’s also important to consider fixed costs versus variable costs. Variable costs differ from discretionary and committed fixed costs in that they often change every month. For instance, if your company uses advertising on social media and pays per click, you may find that in some months you spend $100, while you are charged over $1,000 in others. This cost is wholly dependent on how effective the advertisement is and on how many people choose to click on it.
Some costs may be fixed or variable, depending on how you structure your business. For instance, the amount of money you owe in payroll each month could be a fixed expense if your employees are salaried and paid the same amounts regardless of how many hours they work. If your staff is comprised of commission-based salespeople or hourly workers, however, monthly payroll expenditures will likely vary. In instances like these, it's wise to set aside extra money to account for the ebbs and flows that you can expect.