Step costs definition
/What are Step Costs?
A step cost is a cost that does not change steadily with changes in activity volume, but rather at discrete points. The concept is used when making investment decisions and deciding whether to accept additional customer orders. A step cost is a fixed cost within certain boundaries, outside of which it will change. When stated on a graph, step costs appear to be incurred in a stair step pattern, with no change over a certain volume range, then a sudden increase, then no change over the next (and higher) volume range, then another sudden increase, and so on. The same pattern applies in reverse when the volume of activity declines.
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Understanding Step Costs
Step costing is extremely important to be aware of when a company is about to reach a new and higher activity level where it must incur a large incremental step cost. In some cases, incurring the extra amount of a step cost may eliminate profits that management had been expecting with an increase in volume. If the increase in volume is relatively minor, but still calls for incurring a step cost, it is possible that profits will actually decline; a close examination of this issue may result in a business turning away sales in order to maintain its profitability.
Conversely, a company should be aware of step costs when its activity level declines, so that it can reduce costs in an appropriate manner to maintain profitability. This may require an examination of the costs of terminating staff, selling off equipment, or tearing down structures.
The point at which a step cost will be incurred can be delayed by implementing production efficiencies, which increase the number of units that can be produced with the existing production configuration. Another option is to offer overtime to employees, so that the company can produce more units without hiring additional full-time staff.
Step Costing Best Practices
Given the importance of step costs to the profitability of a business, it makes sense to clearly identify the activity levels at which these costs will be incurred. As long as management understands when these costs will be incurred, it can plan operations to avoid them for as long as possible, thereby maintaining the highest possible level of profits. Consequently, consider including a discussion of step costs in the annual budget.
Example of Step Costs
Here are several examples of the step cost concept:
Expanded facility step costs. The cost of a production facility remains steady over time, but management now wants to build out the facility to accommodate an additional production line. When this happens, the facility cost will increase to a new and higher level, since the entity will incur new costs to maintain the additional floor space, to heat and air condition it, insure it, and so forth.
Increased number of shifts step cost. A company can produce 10,000 widgets during one eight-hour shift. If it receives additional customer orders for more widgets, then it must add another shift, which requires the services of an additional shift supervisor. Thus, the cost of the shift supervisor is a step cost that occurs when the company reaches a production requirement of 10,001 widgets. This new level of step cost will continue until yet another shift must be added, at which point the company will incur another step cost for the shift supervisor for the night shift.
Supervision of sales department. A sales department has one sales supervisor who can manage up to 10 sales representatives. As long as the sales force remains at 10 or fewer, the supervisor’s salary of $70,000 per year remains unchanged. However, if the company decides to expand its sales team to 11 or more representatives, it must hire a second supervisor, causing the supervisory salary expense to "step up" to $140,000 annually. This cost does not increase smoothly with each additional salesperson but rather jumps in increments when a certain threshold is exceeded.
Terms Similar to Step Costing
A step cost is also known as a stepped cost or a step-variable cost.