What is Step Cost?

Step cost refers to the cost that doesn’t change to the changes in activity levels but instead changes after a certain threshold is crossed. The cost follows the pattern of “steps.”

Explanation

You must have heard of variable costs that change in the same proportion as the activity level increases. For example, if the activity level increases by 20%, the variable cost increases by 20%. On the contrary, the cost changes disproportionately in the case of step cost. This is because it follows a step pattern, which means it remains constant up to a certain activity level (e.g., production level). After the activity level reaches the next level, it increases. Similarly, if the activity level is reduced to a previous level, the cost decreases.

How to Calculate Step Cost?

It is based on the level of activity that a business is operating in. Therefore, if you need to calculate relating to any business or a division, you need to follow the below steps:

  • Identify the costs associated with each level of activity. For example, suppose the cost of electricity for producing up to 5,000 units is $10,000; the cost increases to $12,000 once the number of units goes above 5,000. Further, the cost increases to $15,000 once the units are produced to exceed the next activity level, 10,000. It would help if you properly defined the cost relating to different activity levels.Determine the activity level at which the business is operating based on the activities being carried out.Based on the activity level that the company is currently operating at, identify the cost relating to the said level.Suppose you need to check the incremental step cost. In that case, you can find the difference between the business’s costs at the current activity level and the previous activity level.

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Example

Let us understand the calculation in detail with the help of an example.

Carrying on the above discussion, let us suppose the electricity expenses incurred by the company for various activity levels (i.e., production level) is as follows:

This example mentions the cost relating to various activity levels (i.e., units produced). Suppose the company is operating at a production capacity of 18,000 units.

As per the applicable threshold, the step cost for 18,000 units is $20,000 since the activity level lies in the last threshold of 15,001-20,000 units.

Further, the incremental step cost for each activity level is calculated as below:

Applications

The concept of step cost is applicable mainly when the company is about to reach the next higher activity level. In such a case, the management has to carry out a cost analysis; they need to decide the additional cost that the business will incur if it takes its business activity level to the next stage. This incremental cost is then compared with the additional revenue that the company is expected to earn. Accordingly, a decision is taken as to whether it is feasible to move to the next activity level. If the incremental revenuesIncremental RevenuesIncremental Revenue is the additional revenue a Company generates due to the boost in sales throughout a given period. It is determined as the ratio of Change in the Revenue to Change in the Quantity told. read more are greater than the incremental cost, the management makes the necessary investment of incremental cost. However, if the returns fall below the incremental cost, the activity level is not increased.

Importance

Step cost is an important factor in deciding whether the business’s activity level can be increased or not, based on the incremental benefit that the decision will bring. The company can decide whether it is profitable to move to the next activity level, considering the additional step cost that the company will incur. Thus, it helps the company decide to increase or decrease the business activity level.

This has been a guide to what step cost is and its definition. Here we discuss examples, applications, and calculations along with their importance. You may learn more about financing from the following articles –

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