What are discretionary costs?

Learn about discretionary costs, view examples of such costs, and understand instances where discretionary costs may be changed to manage earnings.

1. Definition of discretionary costs 

Discretionary costs are expenses that are important for the business but are subject to management’s judgment (discretion).

Discretionary costs are essentially voluntary costs incurred by an entity to meet customer expectations or create goodwill.

Discretionary costs are opposite to committed costs – i.e., expenses that an entity must incur to operate. Usually discretionary costs represent funding for a specific activity (or project) for a specified period of time.

Examples of discretionary costs are listed below (non-exhaustive list):

• Advertising
• Employee training and development
• Employee travel
• Executive retreats
• Repairs and maintenance
• Research and development (R&D)
• Quality control
• Social responsibility

It’s often difficult to measure the benefits of incurring discretionary costs because there is usually no clear relationship between cost input and product (service) output. As the result, when earnings decrease, an entity might cut discretionary costs first.

To evaluate output from discretionary costs, an organization could use nonmonetary measures: some examples are provided in the table below.

Discretionary Cost	Nonmonetary Measure of Output
Advertising	Increased unit sales Increased market differentiation of the products Increased price premiums Increased numbers of coupons clipped and redeemed
Employee training	Increased employee effectiveness Improved employee recruitment and retention Improved product (or service) quality Improved organizational performance and productivity
Preventive repairs and maintenance	Reduced equipment or process failures Decreased unplanned downtime Increased component life cycle Extended equipment life Increased equipment reliability
Quality control	Improved quality of products or services Improved productivity Increased customer satisfaction and loyalty
Social responsibility	Increased value of the firm Increased market differentiation of the products Increased price premiums Competitor advantage opportunities Decreased litigation risk Increased entry-barriers for potential competitors

2. Discretionary costs and earnings management 

Reduction of discretionary costs is an example of earnings manipulation through real activities (i.e., operating, investing, and financing activities). Note, however, that not every reduction of discretionary costs represents earnings management.

According to the research study by Graham et al (Journal of Accounting and Economics, December 2005), 80% of surveyed CFOs stated that they would decrease advertising, maintenance, and R&D costs to meet earnings expectations.

Because discretionary costs are subject to management’s judgment, they can be used to manage earnings. An organization can decrease its discretionary costs not only to address financial problems but also to smooth its earnings trend. In the latter case, the organization would lower the quality of its earnings.

While the reduction of discretionary costs might seem to be acceptable in the short term, it can have a negative effect in the long run if the company doesn’t incur costs necessary for future growth.

To evaluate any reduction of discretionary costs, one can look at the past trend in discretionary costs as well as current and future requirements, based on corporate strategy and market conditions. For instance, to evaluate a trend in advertising costs, one can look at the relationship between advertising costs and sales. 

Let’s look at a simple example. Let’s assume that the following information is available for Tetto Company (a fictitious entity):

	20X8	20X9	20X0	20X1	20X2
Sales ($)	200,000	225,000	260,000	250,000	210,000
Advertising costs ($)	21,000	27,000	31,000	30,000	20,000

As we can see from the table above, in 20X2 the company decreased its advertising expenses by $10,000 (or 33%). Let’s assume that the company has been facing a tougher competition and expects the competition to increase in the next two (2) years.

To evaluate the reduction in advertising costs in 20X2, let’s look at the trend in advertising-to-sales ratio:

	20X8	20X9	20X0	20X1	20X2
Sales ($)	200,000	225,000	260,000	250,000	210,000
Advertising costs ($)	21,000	27,000	31,000	30,000	20,000
Advertising to sales	10.50%	12.00%	11.92%	12.00%	9.52%

 

According to the table above, in 20X2 the company reduced its advertising costs to a lower level. However, because the market competition is expected to increase, one could anticipate that the company should have increased its advertising costs. Such a reduction of discretionary costs, therefore, might have been used by the company to smooth its earnings.