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.

BREAKING DOWN '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.

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 other).

Watch Your Step

It may make sense to incur higher step costs if revenue is sufficient to cover the higher cost and provide an acceptable return. This may depend on the volume of activity, whereby smaller increments of volume would not be as profitable (or profitable at all) than a larger volume increase. If it is just a small increment, then management of a firm may try to squeeze out more productivity out of existing operations instead of incurring stepped-up costs.

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