High-Low Method
The high-low method is a way to estimate the variable and fixed components of a mixed cost. Mixed costs are costs that have both variable and fixed elements. For example, a utility bill might have a fixed base charge plus a variable charge based on usage.
The high-low method involves two steps:
- Identify the periods with the highest and lowest levels of activity or volume.
- Use the cost and activity levels from those periods to calculate the variable cost per unit and the fixed cost.
Here’s how you calculate it:
- Variable cost per unit = (Cost at highest activity level – Cost at lowest activity level) / (Highest activity level – Lowest activity level)
- Total fixed cost = Total cost – (Variable cost per unit x Activity level)
The variable cost per unit is the change in cost divided by the change in activity. The fixed cost is what’s left over after the variable costs have been accounted for.
It’s worth noting that the high-low method provides a simplified estimation and assumes that costs are strictly linear, which might not always be the case in reality. In addition, it only considers two points of data (the highest and lowest activity levels), which could be outliers and may not represent typical costs. This is why some businesses prefer to use more sophisticated statistical methods, like regression analysis, to estimate variable and fixed costs when a larger data set is available.
Example of the High-Low Method
Imagine that you run a factory, and you’re trying to calculate the electricity cost, which is a mixed cost with both fixed and variable elements. You’ve observed the following over the past year:
- In the busiest month, you produced 10,000 units at a total electricity cost of $5,000.
- In the slowest month, you produced 2,000 units at a total electricity cost of $2,500.
You can calculate the variable cost per unit using the high-low method as follows:
Variable cost per unit = (Cost at highest activity level – Cost at lowest activity level) / (Highest activity level – Lowest activity level)
Variable cost per unit = ($5,000 – $2,500) / (10,000 units – 2,000 units) = $0.3125 per unit
This means that for each unit you produce, you spend approximately $0.3125 on electricity.
To calculate the fixed cost, you can choose either the high or low point. Let’s use the data from the busiest month:
Total fixed cost = Total cost – (Variable cost per unit x Activity level)
Total fixed cost = $5,000 – ($0.3125 per unit * 10,000 units) = $1,875
So, your fixed cost for electricity, regardless of the number of units you produce, is approximately $1,875. This amount should be paid even if there is no production activity.
Remember, the high-low method is a simplified tool and makes several assumptions, so the numbers you get are approximations. If you need more precise estimates, you may need to use more sophisticated cost accounting techniques.
