What Are Step Costs?
Step costs are expenses that are constant for a given level of activity, but increase or decrease once a threshold is crossed. Step costs change disproportionately when production levels of a manufacturer, or activity levels of any enterprise, increase or decrease. When depicted on a graph, these types of expenses will be represented by a stair-step pattern.
- Step costs remain fixed for a certain level of output, but once they cross a certain threshold they increase (or decrease) in step-like fashion.
- Understanding step costs is especially important during times of demand surges or bottlenecks.
- Companies may adjust their production to operate just below a step cost threshold to keep costs down.
Understanding Step Costs
Step costs move up and down in a step-like manner—horizontally over a range, then vertically, then horizontally, and so on. For a given level of activity, a business will incur a fixed cost, but once it reaches another level of activity, its cost to accommodate the additional business increases disproportionately (i.e., not marginally), with a step up higher. The opposite is true, too—if business activity slackens, a material portion of costs will drop, with a step-down.
It is not unheard of for a business to decide against taking steps to increase volume in order to maintain profitability at current levels.
Examples of Step Costs
A high-tech gear manufacturer makes 400 virtual reality headsets in one shift of eight hours with 25 employees and one supervisor. All of the headsets are shipped out, and there is no inventory. Wages and benefits for these employees amount to $6,500 per shift.
Then, demand increases by one headset. Because the production line is at full capacity, the company must add another shift to manufacture 401 units to 800 units. The labor cost to produce 401 units stepped up from $6,500 to $13,000.
A coffee shop can serve 30 customers an hour with one employee. If the shop receives anywhere from zero to 30 customers per hour, it will only need to pay the cost of having one employee, say $50 ($20 for the employee, $30 for all other expenses, fixed and operating). If the shop begins receiving 31 or more customers per hour, it must hire a second employee, increasing its costs to $70 ($40 for two employees, $30 for others).
Understanding step costing is extremely important when a company is about to reach a new and higher activity level, where it will be required to traverse a large step cost. In some cases, the step cost may eliminate profits that management had been expecting with increased volume.
It may make sense to incur higher step costs if revenue is sufficient to cover the higher cost and provide an acceptable return. If the increase in volume is relatively minor, but still calls for incurring a step cost, profits may actually decline. If it's just a small increase in volume, management may try to squeeze out extra productivity from existing operations, instead of incurring stepped-up costs.
Just as management may need to step up costs, they may also need to step down when the activity level declines below a certain threshold. In such cases, management may choose to reduce or eliminate the associated step fixed cost.