What is a Discretionary Expense?
A discretionary expense is a non-essential expense that is incurred by an individual, household, or business. Another way to think of discretionary expenses is to classify them as “wants” instead of “needs.”
A common example is when an individual purchases a new smartphone whenever the latest edition comes out. It is a purchase that helps the individual feel good but hardly relates to the individual’s survival.
Understanding Discretionary Expenses
Discretionary expenses can be incurred in the following situations:
Households and Individuals
An economy is made up of many households and individuals. The economy grows through increased production and spending, and the individuals within a market-based economy spend a lot without even thinking about it.
Some of the expenditures are necessary expenses – food, water, clothing, and shelter. However, most of the expenditures in modern society are discretionary expenses.
Most individuals receive some sort of income. The amount of income remaining after paying off all necessary expenses is known as discretionary income. It can be spent on goods and services or saving/investing at the individual’s discretion.
Also, various essential expenses exist. Some are required by law, while others are necessary for survival. Such expenses can be taxes, various forms of insurance, rent, food, transportation, etc. Usually, an individual faces no choice but to shoulder the expenses.
Every other expense is classified as a discretionary expense. They include vacations and luxury goods and services.
In microeconomics, discretionary expenses are considered more price elastic. Price elasticity refers to the sensitivity of individuals to the price of goods and services. Necessary items are price inelastic since no matter how much they are, we are still going to pay for them.
Whereas if discretionary items become more expensive, they can be cut out of an individual’s budget more easily. During an economic recession, many individuals are fearful of losing their jobs, and therefore, will cut down on discretionary expenses.
Certain costs may be discretionary for some businesses but essential in others. For instance, an internet connection is crucial for a cloud storage company to operate. However, a retail store may be able to run without it. Training costs may be essential expenses for a company, but discretionary for another.
If a recession occurs, discretionary expenses will be the first expenses to be cut by a business.
Investments are also discretionary expenses for businesses. Merger & acquisition (M&A) activity is a discretionary expense that is used as part of its strategy to supplement its operations or for growth.
Companies that sell discretionary products or that provide discretionary services are fairly cyclical businesses. It means that their revenues and earnings fluctuate over time.
When there are economic contractions, there is less demand for their products and services. Companies must be competent in controlling their costs, and must not take on too much leverage to weather economic downturns.
Leverage comes in two main forms:
- Operating leverage is applied when a company takes on more fixed costs as opposed to variable costs. This amplifies the impact of revenue increases flowing to the bottom line. However, it also amplifies the impact of revenue decreases.
- Financial leverage is applied when a company takes on more debt. It amplifies the impact of revenue increases and decreases flowing to the bottom line.
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