## 5. Step-variable costs

We have defined two basic types of costs: variable and fixed. Another cost type is step-variable, 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, and (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 Company would hire four employees (three employees won't be enough because three employees can only produce 300 valves). If the valve production requirement is increased to 400 units, four workers will still be able to cope with the work load. However, for 410 valves, an additional, fifth employee would be needed. Thus, the company's payroll costs change in steps, from costs for four employees at 320 or 400 units, to payroll costs for five employees at 410 units.

Illustration 9: Step-variable cost graph

Illustration 9 describes step-variable payroll costs, where the width of each step represents the volume of activity (i.e., valve production) needed before the step-variable costs increase to the next level (i.e., 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. Note that a narrow width means that a step-variable cost is sensitive to fairly small fluctuations in related activity.

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

Illustration 10: Examples of step-variable costs

 Type of Business Cost Cost Driver Manufacturing Number of workers Number of units produced Restaurant Number of waiters Number of clients Hotel Number of housekeepers Number of rooms occupied Hospital Number of nurses Number of patients
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