Step costs are expenses that remain fixed for a range of workload, but then suddenly change after crossing a certain threshold level. When represented on a graph, step costs follow a stair-step pattern.
Let’s examine how step costs work, why they’re different from other costs, and how they can affect your business expenses.
Definition and Examples of Step Costs
Step costs are expenses that remain constant for a range of workload. The costs will not fluctuate for a certain range of output, but will abruptly rise or fall after crossing a threshold level. When you map out step costs on a graph, they reveal a stair-step pattern.
- Alternate names: Step-fixed cost, stair-step cost, stepped cost, step-variable cost
With pricing for accounting software Quickbooks, for example, your costs can increase or decrease based on the number of user accounts needed. For the Essentials Plan of $30 per month, you can create up to three user accounts. The $30 cost remains constant whether you create just one user account or three. The moment you need a fourth account, your costs jump to $40 per month with the next level plan.
Other examples of step costs for companies include salaries and benefits, which remain a constant cost until a single sharp increase.
How Step Costs Work
For a step cost to occur, the workload must either increase or fall below a certain threshold level.
When the activity rises above a certain level, the step cost will increase. Consider an example where a production company typically produces 1,000 units in one shift. If demand rises to 1,050 units, the company might create an additional production shift to manufacture more units. The step cost incurred would be the salaries as the company would pay additional salaries for shift supervisors to oversee the additional shift.
The same pattern applies when activity falls below a certain level. For example, if a company's sales were not doing well, management may sell off an entire production line. The step cost for several expenses would abruptly decrease since all expenses related to that production line would be cut.
The threshold for incurring a step cost does not always have a hard number. A customer service manager, for instance, may not hire a new representative in response to a small (but greater than usual) increase in emails and phone calls. The manager may wait until there is enough additional work to support a full-time representative before hiring.
Understanding step costs are useful because they help business owners decide whether rising above that threshold line would be a profit or loss to the company.
When a company is growing, the higher output can introduce sudden rises in step costs. In some cases, this growth can be a boon to the company’s revenue. There are times, however, when crossing that threshold line for step costs can result in a loss.
Here’s a simplified example. John is thinking about buying a machine that produces 1,000 units and costs $5,000. Each unit can sell for $20. The revenue generated would be $20,000 (1,000*$20). After subtracting $5,000 for the cost of the machine, the net profit would total $15,000.
After doing market research, John is certain that he’d have demand for at least 1,050 units. This would require buying a second machine, incurring a step cost of $5,000. The revenue generated from only 50 additional units from that machine, however, is only $1,000. Exceeding the threshold (1,000 units) in this case, the step cost ($5,000) would be higher than the revenue generated ($1,000), causing the company to lose profits.
If you need to delay the sudden jump in step costs, consider offering overtime to employees. Overtime shifts can help you produce more units without hiring additional full-time staff. You also avoid or delay additional costs related to recruiting, onboarding, and training.
Types of Step Costs
If you look at your business finances, you’ll discover that many of your expenses are examples of step costs.
When opening a new production facility, business owners will need to consider the additional step costs in employee salaries and equipment. Health care and pension contributions can also fluctuate when staffing levels rise or fall below a certain threshold.
Many prisons and jails analyze step costs based on annual prisoner cohort numbers. If cohorts are fewer, step costs fall because there are fewer people to feed, clothe, and monitor. This also leads to decreased demand for staff for those types of labor.
Step Costs vs. Fixed Costs vs. Variable Costs
|Step Costs||Fixed Costs||Variable Costs|
|Costs that remain fixed for a certain range of workload or output but suddenly change after exceeding or falling below that range||Costs that remain fixed and do not change even if workload or output changes||Costs that change immediately as workload or output increases or decreases|
|Examples: salaries, employee benefits, software subscription plans||Examples: rent, utilities, loan payments||Examples: overtime, contracted services, travel, fuel, supplies|
- Step costs are costs that remain fixed until a certain threshold is reached.
- Step costs can abruptly rise due to higher work output or fall due to lower work output.
- When displayed on a graph, the sudden rise or fall in step costs reveals a stair-step pattern.
- Understanding step costs helps business owners decide whether incurring a jump in step costs would be a profitable investment or cause a loss to the business.