We have defined two basic types of costs which are variable costs and fixed costs. Another cost type is a step-variable cost which is defined as follows:

Step-variable costs are costs that stay fixed over a range of activity, and then change after this range is overcome. In other words, these costs change in increments.

Step-variable costs include characteristic of both variable and fixed costs in a way that (a) step-variable costs do change as production level changes, althrough (b) step-variable costs change only when a production level (range of activity) is overcome. Within that range of activity, step-variable costs remain fixed. The major differences between step-variable costs and fixed costs are that step-variable costs are changed by activity (rather than by a management decision) and step-variable costs are more easily changed compared to fixed costs.

To illustrate step-variable costs, let us return to our example with valve production. One employee can operate equipment to produce 100 valves per day. If 320 valves need to be produced, Friends Corporation would hire four employees (three employees won't be enough because three employees can only produce 300 valves). If the valves production requirement is increased to 400 units, four workers will still be able to cope with the load. However, for 410 valves, an additional, fifth employee would be needed. Thus, the payroll costs change in steps, from costs for four employees for 320 units and 400 units, to payroll costs for five employees for 410 units.

Illustration 9: Step-variable cost graph

Illustration 9 describes a step-variable payroll cost, where the width of each step represents the volume of activity (valves production) needed before the step-variable cost increases to the next level (an additional employee is hired). Once the next level is achieved, the payroll costs increase and remain constant until the next level is achieved again. Narrow width means that cost is sensitive to fairly small fluctuations in related activity.

Other examples of step-variable costs and their cost drivers are provided in the Illustration 10.

Illustration 10: Examples of step-variable costs