The high-low method is used to calculate the variable and fixed cost of a product or entity with mixed costs. It considers the total dollars of the mixed costs at the highest volume of activity and the total dollars of the mixed costs at the lowest volume of activity. The total amount of fixed costs is assumed to be the same at both points of activity. The change in the total costs is thus the variable cost rate times the change in the number of units of activity. The High-Low method of costing provides a useful cost splitting method. The method is a simple mathematical equation that splits the semi-variable costs into variable and fixed costs.
The cost of lower activity is deducted from the cost of higher activity and the resultant is written in the numerator. Similarly, a low level of production is deducted from a higher level of production and placed in the denominator. In other words, a difference in the cost is divided by the difference in the level of production. Its drawback, however, is that not all data points are considered in the analysis.
- The one element of the total cost then provides the second element by deducting it from the total costs.
- It considers the total dollars of the mixed costs at the highest volume of activity and the total dollars of the mixed costs at the lowest volume of activity.
- The challenge of the high-low method is therefore to calculate, or at least estimate, the variable costs accurately.
- It makes use of certain techniques to deduct an element of fixed cost from the total cost.
Such a cost function may be used in budgeting to estimate the total cost at any given level of activity, assuming that past performance can reasonably be projected into future. ABC International produces 10,000 green widgets in June at a cost of $50,000, and 5,000 green widgets in July at a cost of $35,000. There was an incremental change between the two periods of $15,000 and 5,000 units, so the variable cost per unit during July must be $15,000 divided by 5,000 units, or $3 per unit. Since we have established that $15,000 of the costs incurred in July were variable, this means that the remaining $20,000 of costs were fixed.
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The end result may not be as accurate as with other approaches but will generally be more than sufficient for most purposes, especially for SMEs. Pick either the highest or lowest level of activity and fill in what we know. It can be calculated by subtracting the present realizable salvage value from the book value. For example, buying 2,000 shares of company A at $10 a share, for instance, represents a sunk cost of $20,000. They differ in how they change as a result of changes in various business activities such as increased or decreased production, plans of expansion, budgeting for the firm, investing, etc.
The high-low method can also be done mathematically for accurate computation. The main disadvantage of the high-low method is that it oversimplifies the relationship between cost and production activity by only taking the highest and lowest data points into account. This can be used to calculate the total cost of various units for the bakery. So the highest activity happened in the month of Jun, and the lowest was in the month of March.
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Although the high-low method is easy to apply, it is seldom used because it can distort costs, due to its reliance on two extreme values from a given data set. The high-low method is a technique for estimating the fixed and variable components of a mixed cost by analyzing data from high and low activity levels. High low method uses the lowest production quantity and the highest production quantity and comparing the total cost at each production level. It uses only the lowest and highest production activities to estimate the variable and fixed cost, by assuming the production quantity and cost increase in linear. It ignores the other points of productions, so it may be an error when the cost does not increase in a linear graph.
High-Low Method Formula
The high-low method is a cost accounting technique that compares the total cost at the highest and lowest production level of business activity. It uses this comparison to estimate the fixed cost, variable cost, and a cost function for finding the total cost of different production units. Fixed costs are monthly expenses that do not change depending on the level of production. Rent, depreciation, interest on loans, and lease charges are all examples. A cost that contains both fixed and variable costs is considered a mixed cost. The high-low method separates fixed and variable costs from the total cost by analyzing the costs at the highest and lowest levels of activity.
Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable and fixed costs, we have total and fixed costs. In many cases, the variable costs identified under the high-low method can be different statement of retained earnings from other cost methods. The direct costing methods of calculating the variable cost per unit provide accurate figures that consider costs related to the production. Also, the mean or the average variable cost per unit for longer periods can provide more realistic figures than taking extreme activity levels.
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The results of high-low modelling are only valid for as long as the data underpinning them is valid. This means that businesses will need to repeat the high-low modelling exercise periodically to refresh the figures. How much this matters depends on the extent of the variation between the pricing levels. If it’s fairly low, then it might be pragmatic just to accept it as the impact should be minor.
Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. If service contracts use variable pricing, there is a strong possibility that this pricing is tiered. There is also a strong possibility that the rate of increase is non-linear. In other words, as your usage increases, the price-per-unit decreases. This can effectively make it impossible to get a true average variable cost.
Formula
Similar to management accounting and financial accounting, there is cost accounting to determine the cost of a product. The next step is to calculate the variable cost element using the following formula. The first step is to determine the highest and lowest levels of activities and the units produced against each of these levels. The high-low method involves three main steps to calculate the cost for any level of production.
