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:
- 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.
Examples of step fixed costs include:
- The cost of starting up a new production shift, which includes utilities and the salaries of shift supervisors.
- The cost of a new production facility, which includes depreciation on the equipment and the salaries of the production line supervisors.
- The cost of rolling out an entirely new sales region, which may include the cost of a warehouse distribution system.