High Low Method For Fixed Costs

The High-Low Method for Fixed Costs: A Comprehensive Guide

The high-low method is a simple technique used in cost accounting to separate fixed and variable costs from a mixed cost. A mixed cost, also known as a semi-variable cost, contains both fixed and variable components. Understanding these components is crucial for accurate budgeting, forecasting, and pricing decisions. While the high-low method offers a straightforward approach, it's essential to understand its limitations and consider more sophisticated methods for greater accuracy. This comprehensive guide will delve into the high-low method, exploring its applications, calculations, limitations, and alternatives.

Understanding Mixed Costs

Before diving into the high-low method, let's solidify our understanding of mixed costs. These costs exhibit characteristics of both fixed and variable costs.

• Fixed Costs: These remain constant regardless of the production volume or activity level. Examples include rent, salaries of administrative staff, and insurance premiums.

• Variable Costs: These fluctuate directly with changes in production or activity. Examples include direct materials, direct labor (in some cases), and sales commissions.

A mixed cost, therefore, has a fixed component that is incurred regardless of activity and a variable component that changes with activity levels. For example, the cost of operating a delivery truck might include a fixed monthly lease payment and a variable cost component related to fuel consumption, which varies with mileage.

The High-Low Method: A Step-by-Step Guide

The high-low method isolates fixed and variable costs by analyzing the highest and lowest activity levels and their corresponding total costs. Here's a step-by-step guide:

1. Identify the Highest and Lowest Activity Levels: This typically involves reviewing historical cost data over a specific period. The "activity level" refers to the cost driver, which is the factor that influences the variable cost component (e.g., units produced, machine hours, miles driven).

2. Determine the Highest and Lowest Total Costs: For each activity level identified in Step 1, find the corresponding total cost. This total cost includes both fixed and variable components.

3. Calculate the Variable Cost per Unit: This is done using the following formula:

(Highest Total Cost - Lowest Total Cost) / (Highest Activity Level - Lowest Activity Level)

This calculation provides the variable cost per unit of activity.

4. Calculate the Fixed Cost: Once the variable cost per unit is determined, you can calculate the fixed cost using either the highest or lowest activity level data. Here's how:

• Using the highest activity level: Fixed Cost = Highest Total Cost - (Variable Cost per Unit * Highest Activity Level)

• Using the lowest activity level: Fixed Cost = Lowest Total Cost - (Variable Cost per Unit * Lowest Activity Level)

Ideally, both calculations should yield the same fixed cost. Any minor discrepancies might arise due to rounding errors.

5. Develop the Cost Formula: Finally, the cost formula can be expressed as follows:

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

This formula can then be used to predict total costs at different activity levels.

Example: Applying the High-Low Method

Let's consider an example. A company's utility costs over the past six months are as follows:

1. Identify Highest and Lowest:

• Highest Activity Level: 2000 machine hours (April)

• Lowest Activity Level: 1000 machine hours (January)

• Highest Total Cost: $8000 (April)

• Lowest Total Cost: $5000 (January)

2. Calculate Variable Cost per Unit:

Variable Cost per Unit = ($8000 - $5000) / (2000 - 1000) = $3 per machine hour

3. Calculate Fixed Cost:

Using the highest activity level (April):

Fixed Cost = $8000 - ($3 * 2000) = $2000

Using the lowest activity level (January):

Fixed Cost = $5000 - ($3 * 1000) = $2000

Both calculations yield a fixed cost of $2000.

4. Develop the Cost Formula:

Total Cost = $2000 + ($3 * Activity Level)

Limitations of the High-Low Method

While the high-low method provides a simple approach to cost estimation, it has several limitations:

• Sensitivity to Outliers: The method relies heavily on the highest and lowest data points. If these points are outliers (abnormally high or low due to unusual circumstances), the resulting cost estimations will be inaccurate.

• Ignoring Other Data Points: The method ignores all data points except for the highest and lowest. This can lead to a loss of valuable information and a less precise estimation.

• Assumption of Linearity: The high-low method assumes a linear relationship between cost and activity. In reality, the relationship might be non-linear, particularly at very high or low activity levels.

• Inaccuracy with fluctuating variable costs: The method assumes a constant variable cost per unit. If the variable cost itself fluctuates significantly, the accuracy of the high-low method will be affected.

Alternatives to the High-Low Method

More sophisticated methods offer improved accuracy in separating fixed and variable costs:

• Scattergraph Method: This visual method plots historical cost data points on a graph, providing a visual representation of the relationship between cost and activity. While subjective, it can help identify outliers and non-linear relationships.

• Least Squares Regression Analysis: This statistical technique finds the best-fitting line through a set of data points, minimizing the sum of squared errors. It provides more precise estimations than the high-low method and accounts for all data points.

• Account Analysis: This method involves carefully examining each individual cost item and classifying it as either fixed or variable based on its nature. While time-consuming, it offers a more thorough and accurate approach.

Conclusion

The high-low method is a valuable tool for a quick and simple estimation of fixed and variable costs. However, its limitations should be recognized. For greater accuracy, especially in situations with significant data variability or non-linear cost-activity relationships, more sophisticated methods like least squares regression analysis or account analysis should be considered. The choice of method depends on the specific context, data availability, and desired level of accuracy. Understanding the strengths and limitations of each approach is crucial for making informed cost management decisions. Remember to always critically evaluate your results and consider the potential impact of any inaccuracies on your business's financial planning.