Step fixed cost definition

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What is a Step Fixed Cost?

A step fixed cost is a cost that does not change within certain high and low thresholds of activity, but which will change when these thresholds are breached. When the cost changes as a result of a threshold breach, a new set of high and low activity thresholds will then apply, within which the fixed cost will not change appreciably. The concept is useful when deciding whether to invest in capital projects. A threshold breach can result in one of two conditions in regard to a step fixed cost, as noted next:

  • Activity declines. When the activity level declines below the lower threshold level, management has the option of terminating or reducing the associated step fixed cost. For example, if sales volume declines, management could sell off a production line, thereby terminating all associated costs. However, this is only an option - management could instead elect to continue to incur the cost. Doing so allows it to preserve the associated capacity in case the related activity level later increases.

  • Activity increases. When the activity level increases above the upper threshold level, management has the choice of either accepting no additional activity and not incurring an additional step fixed cost, or of accepting the increase in activity and incurring the additional cost. For example, if sales increase to a certain maximum level, management can either turn away any additional customer orders or accept the orders and incur the additional step fixed cost required to process the additional sales.

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Examples of Step Fixed Costs

The following are all examples of step fixed costs:

  • The cost of starting up a new production shift, which includes utilities and the salaries of shift supervisors. Also, if the production line requires a certain fixed number of employees to staff it (irrespective of volume), they can also be considered a step fixed cost, rather than a direct cost.

  • The cost of a new production facility, which includes depreciation on the equipment and the salaries of the production line supervisors. This can be a massive step fixed cost, so managers generally engage in a large amount of what-if modeling to ensure that ongoing sales volumes can realistically support the added cost.

  • The cost of rolling out an entirely new sales region, which may include the cost of a warehouse distribution system. As was the case with a new production facility, the addition of a warehouse distribution system is a major investment, and so calls for a detailed investigation of other options and projected sales levels before managers will agree to this investment.