What is Step Cost?
Step cost refers to the cost that doesn’t change in direct proportions to the changes in activity levels but instead changes after a certain threshold is crossed. The cost follows the pattern of “steps.”
You must have heard of variable costs that change in the same proportion in which the activity level increases. If the activity level increases by 20%, then the variable cost also increases by 20%. On the contrary, in the case of step cost, the cost changes disproportionately. It follows a step pattern, which means that it remains constant up to a certain level of activity (e.g., production level). After the activity level reaches the next level, it increases. Similarly, in case the activity level is reduced to a previous level, then the cost decreases.
How to Calculate Step Cost?
It is based on the level of activity that a business is operating in. 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 defined the cost relating to different activity levels properly.
- Determine the activity level at which the business is operating based on the business activities being carried out.
- Based on the activity level that the company is operating at currently, identify the cost relating to the said level.
- If you need to check the incremental step cost, you can find the difference between the costs that the business will incur on the current activity level and previous activity level.
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:
In this example, the cost relating to various activity levels (i.e., units produced) is mentioned. Suppose the company is operating at the 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:
The concept of step cost is applicable mainly when the company is about to reach the next higher activity level. The management has to carry cost analysis in such a case; they need to decide the additional cost that the business will have to 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, and a decision is accordingly taken as to whether it is feasible to move to the next activity level or not. 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. are greater than the incremental cost, the necessary investment of incremental cost is made by the management. However, if the returns fall below the incremental cost, then the activity level is not increased.
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 is going to 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 make decisions with an increase or decrease in the business activity level.
This has been a guide to what is Step Cost and its definition. Here we discuss examples, applications, and calculations along with importance. You may learn more about financing from the following articles –