What is Committed Cost?
Committed Costs are fixed or budgeted or confirmed payments to be made in future to the vendors for goods or services to be taken, which are necessary for smooth flow of the business and the absence of which may disrupt the main operations of a business which may have credible impact on the company. Examples include rent cost of office, Rental costs of factories, fixed pay for employees, retirement benefits paid to employees, etc.
Examples of Committed Cost
Example #1
Let’s have a look over the types of committed costs:
Explanation
- As you can see, a typical company may have above expenses which are unavoidable & are committed to the character of business.
- These expenses will not stop even if the company is not operating.
Example #2
Let us have a look over how rental cost is calculated –
Explanation
- Escalation means an increase in rental amount per annum. Over 5 years, the rental cost has increased from $ 42500 to $ 51659.
- Even in the wake of COVID-19, companies must bear the rental cost irrespective of whether the factories are running or in an idle state.
- Thus, rental is treated as a committed cost.
Example #3
Say, a hotel is running at location 1 with the following details –
The factory is running at a rental cost of $ 3500,000. But the whole space is not being utilized in the past 3 years due to a lesser number of customers & increase in home deliveries. The hotel management received an offer of similar infrastructure with reduced space & reduced rental costs. The management accepted the offer to shift to location 2.
The initial stages of the hotel at a new location will be difficult to establish. Thus, the details at location 2 are as follows –
Implication
- Shifting of the establishment from location 1 to location 2 has an impact on the main business.
- You can even see at location 2; the hotel has to incur the annual employee costs with no change. Additionally, it has to incur the relocation cost of shifting the hotel premises. The rental is reduced by $ 1400,000, but still, it is committed to cost.
- Since the hotel is new at the location, it will receive fewer orders at the initial stages. Thus, even the materials cost is reduced substantially.
- However, such relocation has an impact on business with the pinch of committed costs and is difficult to alter or change.
- Relocation means shutting down the business at location 1 & restarting at location 2, wherein the hotel has to re-establish its reputation, its goodwill & capturing new customers.
Example #4
Let us have an example of the maintenance cost of new machinery. The details are as follows:
Explanation
- Even if the company is not using the machinery for a few months, it must pay for maintenance costs as agreed.
- Thus, $ 24000 is the committed cost.
Committed Cost vs. Discretionary Cost
| Committed Cost | Discretionary Cost | |
| These costs are fixed in nature. | These costs are fixed with little flexibility from the vendor. | |
| These cannot be avoided at any cost. | These can be made avoidable as per agreement with the vendor. | |
| These are included in budgets, and elimination needs approval from top management. | These are also included in budgets, but elimination does not require higher approvals. | |
| After elimination from the budget, finding better alternatives is difficult. | After elimination from budgets, alternatives can easily be escalated. | |
| The amount of commitment cannot be changed easily. | The amount of discretionary fixed costs can be changed easily. | |
| It cannot be postponed & thus, actual usage is not relevant. | It can be postponed as per the choice of management & thus, actual usage is relevant. | |
| Examples are rent costs, fixed pay of employees, etc. | Examples are variable pay of the employee, performance-linked incentives, advertising costs, etc. |
Advantages
- It confirms the service from the vendor.
- Fixed cost is incurred only once, and hence further decision making is not affected by the committed cost.
- Committed costs ensure the availability of something when needed.
- It works like an advance payment of future goods or services to be received from the vendor.
- An unauthorized person cannot make changes in committed costs.
Conclusion
Committed cost is considerably high in the wake of COVID-19. Many companies are determined to pay the fixed costs (such as rental expenses, AMC, etc.) even if the factories are not operational. Many individuals are also working from home town, but they have to pay rent for the flat in their work town. Committed cost is a burden if the said services/goods are not available for usage due to such outbreaks. On the other hand, a committed one has assured revenue for another. Thus, breaking the chain may cause the economic cycle to break down.
Recommended Articles
This has been a guide to what is Committed Cost and its definition. Here we discuss examples of committed cost along with advantages and its differences from discretionary cost. You may learn more about finance from the following articles –
- Semi-Fixed Cost
- Switching Cost
- Factory Cost
- Cost Overrun
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