The Nature of Step Costs
A step cost is a cost that does not change steadily, but rather at discrete points. A step cost is a fixed cost within certain boundaries, outside of which it will change. For example, a production manager finds that his facility can produce a maximum of 3,000 widgets per week if he uses one shift, but that he needs to start a second shift in order to meet any additional demand. When he adds on the shift, the company will have to incur certain additional fixed costs, such as the salary of a supervisor for that shift.
This is a problem from a budgeting perspective, since costs must be budgeted to increase by relatively large amounts when step cost points are encountered. If you prepare a budget that does not factor in these large expense changes, the budget will likely yield profits and cash flow figures that are much higher than can actually be attained.
Integrating Step Costs into the Budget
To calculate when a step cost will occur, prepare a table that contains all pertinent activities, and the activity levels at which a certain step cost will be incurred. Then work through the latest version of the budget and see if any step costing points will be triggered by estimated activity levels in the budget period. For example, if production is budgeted to increase past one million units per month, this triggers the construction of a new production line at a cost of $5,000,000. Management must be notified of all step costing points breached and the investment required to fund each step cost. Management may make any of the following decisions based on this information:
- Implement efficiencies to delay the step costing point, such as the use of automation
- Outsource production or services in order to avoid the step costing point
- Decide that the extra capacity represented by a step cost will not be needed, and so deliberately scale back the budget to avoid triggering the step cost
The outcome of these decisions will likely be alterations to the budget model, to accept some step costs and avoid others. This process is a key part of the budgeting procedure, to ensure that a workable budget model is created that meshes with a company's cash resources.