A typical problem for anyone constructing a budget is to determine when step costing points occur. A step cost is a block of additional expenses that must be added when a certain level of activity is reached. For example, machinery can only operate at a reasonable capacity level, perhaps 75 percent, before another machine must be added to cope with more work, even if that work load will only fill the new machine at a very low level of capacity. The same principal applies to adding personnel or building space. In all cases, there is some added expense that must be incurred in one large block. If the expense is sufficiently large, it can play havoc with the total level of expenses. Or, in the case of a really large capital purchase, it may leave no room for other capital purchases for the next year. Accordingly, it is necessary to keep close track of step cost change points.
The best way to determine when an increase in step costs will occur is to create a table of activity measures that directly relates to each step cost; then compare anticipated activity levels to the points at which step costs will be incurred, and budget accordingly. For example, a new shipping person is needed for every 135 pallets of product shipped per day. By relating sales for the next year to the number of pallet loads of shipments, you can reasonably predict when an additional shipper is needed. Similarly, if a piece of production machinery will support $1 million of sales, it is an easy matter to extrapolate this relationship based on expected sales to determine when additional machine purchases must be made.
Step costs can be delayed by using new work methods, which can significantly increase the activity levels that must be reached before new step costs must be incurred. For example, an automated shrink-wrapping machine can substantially increase the number of pallets that a single shipper can handle in a day, while a good preventive maintenance machine routine can reduce the amount of machine downtime, thereby increasing utilization rates and delaying the need for more production equipment. When these changes are added to the budget, it becomes necessary to change the relationship between the activity levels and step costs, possibly with the relationships varying over the course of the budgeted period, as more work methods are implemented.
Have a senior-level accountant with a background in cost accounting review the cost structure of the organization to determine the key step costs that may occur during the upcoming budget year. Verify the amount by which costs may change if various levels of activity are reached. Document this information and discuss it with the management team to see if the step cost points are valid, if the itemized cost changes are valid, and if they can be altered by improving efficiency levels. Then incorporate the step costs into the budget model, being sure to also describe them under the assumptions section.