High Low Method For Fixed Cost

High-Low Method for Fixed Cost: A Comprehensive Guide

The high-low method is a simple technique used in accounting to separate fixed and variable costs from a mixed cost. Understanding your cost structure is crucial for accurate budgeting, pricing strategies, and profitability analysis. While not the most precise method, the high-low method provides a quick and easy estimate, especially useful for smaller businesses or those with limited data. This comprehensive guide will delve into the intricacies of the high-low method, examining its application, limitations, and alternatives.

Understanding Mixed Costs

Before diving into the high-low method, let's clarify what mixed costs are. Mixed costs, also known as semi-variable costs, contain both a fixed and a variable component. A fixed cost remains constant regardless of the production volume, like rent or salaries. A variable cost changes directly with production volume, such as raw materials or direct labor. Understanding how to separate these components is vital for accurate cost accounting.

Examples of mixed costs include:

• Utilities: You'll have a base monthly charge (fixed) plus charges based on consumption (variable).
• Telephone expenses: A monthly line rental (fixed) plus charges for calls (variable).
• Maintenance costs: A base level of routine maintenance (fixed) alongside costs for repairs related to production volume (variable).
• Sales commissions: A base salary (fixed) plus commission based on sales volume (variable).

The High-Low Method: Step-by-Step

The high-low method focuses on the highest and lowest activity levels within a given period to estimate the fixed and variable cost components. Here's a step-by-step breakdown:

Step 1: Identify the Highest and Lowest Activity Levels

First, gather your data. This data should consist of the total costs (mixed costs) and the corresponding activity levels (e.g., units produced, machine hours, sales revenue) for a specific period. From this data, identify the period with the highest activity level and the period with the lowest activity level.

Step 2: Calculate the Variable Cost per Unit

The formula to calculate the variable cost per unit is:

(Highest cost - Lowest cost) / (Highest activity - Lowest activity)

This formula determines the change in cost divided by the change in activity, giving you the variable cost per unit.

Step 3: Calculate the Fixed Cost

Once you have the variable cost per unit, you can calculate the fixed cost using either the highest or lowest activity data point. The formula is:

Total Cost - (Variable cost per unit * Activity level)

Using either the highest or lowest activity level should yield the same fixed cost, barring minor rounding differences. This consistency serves as a quick check for your calculations.

Step 4: Develop the Cost Formula

Finally, you can develop a cost formula to predict total costs at different activity levels. The general formula is:

Total Cost = Fixed Cost + (Variable Cost per Unit * Activity Level)

This formula allows you to estimate the total cost for any given activity level within the relevant range.

Example: Applying the High-Low Method

Let's illustrate the high-low method with an example. A company has the following data on its total maintenance costs and machine hours for the past six months:

Step 1: The highest activity level is 2500 machine hours (June) with a cost of $8,000. The lowest activity level is 1000 machine hours (January) with a cost of $5,000.

Step 2: Variable cost per unit: ($8,000 - $5,000) / (2500 - 1000) = $2 per machine hour

Step 3: Fixed Cost (using highest activity): $8,000 - ($2 * 2500) = $3,000

Step 4: Cost Formula: Total Maintenance Cost = $3,000 + ($2 * Machine Hours)

This formula suggests that the fixed maintenance cost is $3,000 per month, and the variable cost is $2 per machine hour.

Limitations of the High-Low Method

While straightforward, the high-low method has several limitations:

• Sensitivity to Outliers: The method relies heavily on the highest and lowest data points. If these points are outliers (unusually high or low due to factors unrelated to typical operations), the resulting cost estimations will be inaccurate.
• Ignoring Data Points: The method only uses two data points, ignoring the information contained in the remaining data. This can lead to a less precise estimate compared to methods that consider all data points.
• Linearity Assumption: The high-low method assumes a linear relationship between cost and activity. In reality, cost behavior might be curvilinear or step-wise, invalidating the linear assumption.
• Simple Estimation: It offers a rough estimate rather than a precise calculation. More sophisticated methods are needed for higher accuracy.

Alternatives to the High-Low Method

Several alternative methods offer more precise cost estimations:

• Scattergraph Method: This visual method plots all data points on a graph to identify the best-fit line representing the cost behavior.
• Least Squares Regression: A statistical method that uses all data points to determine the line of best fit, minimizing the sum of squared errors. It provides more accurate estimates compared to the high-low method.
• Account Analysis: This method involves carefully examining each cost item to classify it as fixed or variable. It's subjective but useful when detailed cost information is available.

Conclusion: When to Use the High-Low Method

The high-low method is best suited for situations requiring a quick, simple estimate of fixed and variable costs when data is limited or when a high level of accuracy is not crucial. It serves as a useful starting point for cost analysis, especially for smaller businesses or for preliminary assessments. However, for more accurate and reliable results, especially when dealing with significant data sets or when the relationship between costs and activity isn't strictly linear, consider employing more sophisticated methods like least squares regression or the scattergraph method. Understanding the limitations and alternatives ensures that you select the most appropriate method for your specific needs and ensures the accuracy of your cost estimations. Remember that effective cost accounting is vital for informed business decisions, accurate budgeting, and maximizing profitability.