Step cost

Step cost
See also
Differential costing Step fixed cost Cost behavior Target cost Cost model Hidden cost Absorbed costs Product cost Cost oriented pricing

Step cost is a cost which has a tendency to remain fixed in total over various small ranges of production but increase by separate amounts as the activity level increases from one range to another. Inputs which are acquired in discrete quantities but whose usage takes place in fractional quantities show this type of behaviour.

Step costs classification

Depending upon the period up to which an expense can be kept up to a certain level in spite of increase in activity, the height and width of steps vary. Therefore, step costs may be classified:

• step variable costs - costs where steps in step cost function are small and narrow. If the width of the step is narrow, the cost of the resource changes in response to fairly small changes in resource usage. The behaviour of cost is nearly like that of pure variable cost,
• step fixed costs - costs where steps in step cost function are wider. Cost is said to behave nearly like that of fixed cost.

Step cost function

Some cost functions display characteristics of a discontinuous function. In case of step costs, one such discontinuous function is called a step-cost function. A step-cost function displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point, where it remains for a similar range of activity. Step cost function characteristics are a result of input factors that cannot be increased in very small portions. The appearance of step cost is similar to the stairs or steps in a building.

Real world applications

In reality, many so-called fixed costs may be described by a step-cost function. Many committed resources - particularly those that involve implicit contracting - follow a step-cost function. Step costs stay at the same level for certain activity range (for example, one to four people), but jump to a higher amount if the volume of activity increases beyond this range (adding a fifth person to the group). It is found that all labour costs usually behave in a step-cost manner. The reason underlying this is that it is not possible to store the services of labour. Secondly, when the acquisition of labour takes place, it is done in indivisible lumps. Step-cost function analysis may be beneficial to the company - if managers know the total capacity available as well as the capacity used, they can better utilize the activity capacity and know when additional capacity must be acquired.

Step cost example

Example of this type of cost is the number of supervisors in a factory. One supervisor is in a position to supervise up to an optimum number of workers effectively. Increase in the number of supervised employees raises the need to have another supervisor for the supervision to stay effective. Assuming that one supervisor is in a position to do effective supervision of fifteen workers, a second supervisor would be needed if the number of workers increases to sixteen, a third supervisor if the number of workers exceeds thirty and a fourth supervisor would be needed only if the number of workers exceeds forty but remains within sixty. Therefore, there is a sudden increase in the number of supervisors as the activity level increases from one range to next.

Advantages of Step cost

Step cost can be a beneficial tool for businesses as it allows them to accurately assess and measure the cost associated with producing a product or service. The following are some advantages of step cost:

• Step cost allows businesses to accurately measure the cost of producing a product or service, which in turn, helps them to make more informed decisions.
• Step cost can help businesses to budget and plan more effectively, as they are able to accurately predict the cost of production.
• Step cost can help businesses to identify areas where they can make cost savings by reducing the cost of production.
• Step cost can be used to measure the profitability of a business, as it can be used to calculate the cost of production in relation to the price of the product or service.

Limitations of Step cost

Step costs have a few limitations, such as:

• Step cost does not accurately reflect the variable costs associated with production. It is only an approximation of actual variable costs, and is not reliable for long-term planning or budgeting purposes.
• Step cost calculations can be difficult to establish due to the number of distinct production levels needed to accurately calculate the costs.
• Step cost does not factor in changes in the cost of inputs over time, which can lead to inaccurate calculations.
• Step cost calculations do not take into account any economies of scale that may be present, which could lead to inaccurate cost estimates.

Other approaches related to Step cost

Step cost is not the only approach to managing cost. Other approaches include:

• Activity-Based Costing (ABC): This approach accounting for costs associated with a particular activity or process in an organization. It is based on the idea that activities are the drivers of cost and that costs are more accurately allocated to the activities that cause them.
• Target Costing: This approach focuses on costs that can be controlled through management decisions and actions. It is a cost-reduction strategy that seeks to identify a target cost for a new product and then develop the design, manufacturing process, and business model to meet that cost.
• Life Cycle Costing: This approach takes into account the costs associated with a product over the entire life cycle, from development through production, marketing, and distribution to disposal. It is a tool for evaluating the full cost of ownership for a product over its entire life cycle, including costs such as energy consumption and environmental impact.
• Process Costing: This approach is used to calculate the cost of a process or activity. It is used to calculate the cost of producing a certain number of units of a product or service.

In summary, step cost is just one approach to cost management, but there are other approaches such as activity-based costing, target costing, life cycle costing, and process costing that can be used to manage costs more effectively.

References

• Balakrishnan R., Sivaramakrishnan K., Sprinkle G., (2012), Managerial Accounting, 2nd edition, John Wiley & Sons, Inc., United States
• Dutta, M., (2004), Cost Accounting: Principles And Practice, Pearson Education (Singapore) Pte. Ltd., Indian Branch, 482 F.I.E. Patparganj, Delhi 110 092, India
• Hansen, D. R., Mowen, M. M., (2013), Cornerstones of Cost Management, Cengage Learning
• Layne, W. A., Rickwood, C., (1984), Cost Accounting: Analysis and Control, Macmillan Publishers Ltd., United Kingdom

Footnotes

Author: Gabriela Sambór