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Evaluating Proposals that Involve Additional Costs

What step costs are

One of the CFO’s key roles is to evaluate proposals that involve incremental fixed costs, otherwise known as step costs. As a manager, you may find yourself presenting such proposals. Having a CFO perspective can help you to get the approval you need, or at least avoid wasting time on proposals that have no chance of success.

Step costs are fixed costs that remain constant for a certain level of business activity but change once business activities cross that level. For example, a convenience store may be able to serve 35 customers in an hour with one employee. Up to that point it has to pay the salary, which is fixed cost, of one employee. But if the store begins to receive more than 35 customers an hour, it’ll have to hire another employee and increase its salary cost.

Take as another example a Sales Department of a machine tool company that has five sales support managers. It sells about 100,000 units each month. The department can support sales of up to 105,000 units. After that, the department would need a new sales support manager.

Eighteen months later, the company’s sales drop to around 60,000 units, so the department needs only three sales support managers. The other two managers are assigned to another territory.

The total cost of sales support managers’ salaries would be regarded as a step cost because it incrementally changes as sales levels and output need change. For example, when sales levels fall, or are stepped down, the total salary cost also falls, or steps down.

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