To run a business, you must understand how your business’s costs behave. A fixed cost is any cost that will remain the same, regardless of changes in your sales volume. Variable costs are costs that change with sales volume. The greater your sales, the greater your variable costs.
Step costs change only at certain intervals. For example, suppose that you run a delivery service. A typical truck and driver can make 40 deliveries in a day. The cost of that truck and driver would be a step cost. Whether you need to make 20, 30, 39 or even 40 deliveries in a day, then you need to pay for just one truck and driver. However, if you need to make 41 deliveries in a day, you will need to buy a second truck and hire a second driver – that 41st deliver will double your costs..
Likewise, when you grow your business up to 81 deliveries. You’ll need a third truck and driver.
Step costs create interesting incentives for your business. Suppose that you make 80 deliveries a day. A new customer (who will need two deliveries a day) approaches you. Maybe you should turn away the customer in order to avoid buying another truck and hiring another driver? After all, will the contribution margin from this customer exceed the cost of another truck and driver? Maybe not. Or perhaps you are likely to draw even more customers that will generate sufficient contribution margin to pay for your new truck and driver? Or perhaps you should pay an existing truck driver a little overtime.
To properly make these decisions, you should know how your costs behave, and how your decisions will affect your total costs and your profitability.
[Image: arne jacobsen, rødovre town hall, 1952-1956 by seier+seier, on Flickr]