 Intensified competition

Committed and Discretionary Fixed Costs
The classification of costs as fixed or variable is a simplification made to facilitate short-term planning and
control of a business. Over the long term, all costs are ultimately variable. However, over periods up to about
one year, businesses categorize fixed costs as committed costs or discretionary costs, depending on the
kind of planning and control decisions that drive the related expenditure. Committed costs relate to periods of
several years or more, while discretionary costs correspond to a business’ annual planning period.
Committed Costs. Management’s long-term objectives for increased market share,
expansion into new geographic markets, and product extension are the principal factors
affecting its planning decisions about committed costs. Committed costs relate to periods
beyond the annual planning cycle and largely determine a business’ productive capacity for
an extended period. These costs include principally those for PP&E (also called capital
expenditures or “capex”)10 and for the basic organization needed in order to be ready to
conduct business, such as the labor costs of employees classified as “indirect” (overhead).
For example, a plant must have employees to purchase raw materials and schedule
production before it can manufacture any products. Committed costs also include the costs
of purchased intangible assets (such as licenses of intellectual property developed by
others), and the cost of acquiring a competing business.
Management’s control of committed costs focuses on the business’ return on investment
and asset utilization (turnover), examined in the Topic 8 background paper.
Discretionary Costs. Management’s annual spending plans, reflected in approved
operating budgets, are the principal driver of discretionary costs. Whereas committed costs
generally relate to the amount of productive capacity a business has available, discretionary
costs generally arise from managers’ strategies for generating product demand. These
costs include those for advertising and product promotion, R&D, employee training, and
“special projects” (such as, business process reengineering efforts). In contrast to
committed costs, businesses may reduce or eliminate discretionary costs for a given fiscal
year in response to financial difficulties, to engage in real earnings management11, or both.
While businesses may augment or reduce discretionary costs over relatively short planning
periods, managers faces challenges in measuring objectively the success of such
expenditures because clear cause-and-effect relationships between such costs and
revenues usually do not exist. For example, the amount a business spends on hightechnology
product R&D is only one factor determining sales growth. Other factors include
the rate of success in achieving “technological feasibility” in successive R&D projects, the
size of the potential market demand for new products, the creativity of product promotion,
and the emergence of competing products.
Managers’ difficulty in measuring the effectiveness of such activities highlights the related
difficulty in planning them in the first place.
The operating budget presents managers’ planned sales and operating expenses for the forthcoming fiscal
year of the business.12
Operating expenses include discretionary fixed costs. In contrast, the capital
budget sets forth managers’ approved plans for capital expenditures, which represent committed costs of
assets having long lives, such as PP&E.
10 The Topic 6 background paper examines the capital