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.
For example, a facility cost will remain steady until additional floor space is constructed, at which point the cost will increase to a new and higher level as the entity incurs new costs to maintain the additional floor space, to heat and air condition it, insure it, and so forth.
As another example, a company can produce 10,000 widgets during one eight-hour shift. If the company 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.
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.
A step cost is also known as a stepped cost or a step-variable cost.