In Applying The High-low Method What Is The Fixed Cost

In Applying the High-Low Method, What is the Fixed Cost? A Comprehensive Guide

The high-low method is a simple technique used in cost accounting to separate the fixed and variable components of mixed costs. Understanding how to apply this method correctly is crucial for accurate cost estimations, budgeting, and decision-making. While seemingly straightforward, a common area of confusion lies in precisely identifying the fixed cost element after applying the method. This article will delve deep into the high-low method, explaining its mechanics, potential limitations, and, most importantly, how to definitively determine the fixed cost.

Understanding Mixed Costs

Before diving into the high-low method, let's define what mixed costs are. These are costs that contain both a fixed and a variable component. Fixed costs remain constant regardless of the level of activity, while variable costs change directly in proportion to the level of activity. Examples of mixed costs include:

• Utilities: A base monthly charge (fixed) plus a per-unit consumption charge (variable).
• Maintenance: A regular maintenance contract cost (fixed) plus costs for repairs based on usage (variable).
• Sales commissions: A base salary (fixed) plus commissions based on sales volume (variable).

The Mechanics of the High-Low Method

The high-low method uses the highest and lowest activity levels within a given period to separate the fixed and variable costs. The steps are as follows:

1. Identify the Highest and Lowest Activity Levels

This involves selecting the period with the highest total cost and the period with the lowest total cost. Crucially, the "activity" must be a relevant cost driver. This could be units produced, machine hours, labor hours, or sales volume – anything that directly influences the total cost.

2. Calculate the Variable Cost per Unit

The variable cost per unit is calculated using the following formula:

(Highest Cost – Lowest Cost) / (Highest Activity – Lowest Activity)

This formula effectively determines the change in cost per unit change in activity.

3. Calculate the Fixed Cost

Once the variable cost per unit is known, the fixed cost can be calculated using either the highest or lowest activity level data. The formula for calculating fixed cost is:

Total Cost – (Variable Cost per Unit * Activity Level)

You should use both the highest and lowest activity levels to calculate the fixed cost. If both calculations yield the same or near-identical results, it adds to the reliability of the method's output. Inconsistent results, however, indicate potential issues with the data or suggest the high-low method's limitations are significant in this case.

Example:

Let's say a company's total costs for two months were:

• Month 1 (Low): Activity = 1,000 units; Total Cost = $5,000
• Month 2 (High): Activity = 2,000 units; Total Cost = $8,000

1. Variable Cost per Unit: ($8,000 - $5,000) / (2,000 - 1,000) = $3 per unit

2. Fixed Cost (using high activity level): $8,000 - ($3/unit * 2,000 units) = $2,000

3. Fixed Cost (using low activity level): $5,000 - ($3/unit * 1,000 units) = $2,000

In this example, the fixed cost is $2,000.

What the Fixed Cost Represents in the High-Low Method

The fixed cost derived from the high-low method represents the estimated fixed cost component of the mixed cost. It's important to remember that this is an estimation. It assumes a perfectly linear relationship between activity and cost, which is often not entirely true in real-world scenarios. There might be non-linear factors affecting the cost, rendering the high-low method's result an approximation.

The fixed cost identified doesn't necessarily represent all the truly fixed costs within the business. It only accounts for the fixed portion of the specific mixed cost being analyzed. The fixed cost component of the mixed cost is isolated from the total cost by analyzing the changes from the lowest to the highest activity level. Therefore the final value represents the fixed portion of the cost under examination.

Limitations of the High-Low Method

The high-low method is a relatively simple technique, but it has several limitations:

• Sensitivity to Outliers: The method relies heavily on the highest and lowest data points. If either of these points is an outlier (an unusually high or low value), the calculated fixed and variable costs will be significantly skewed.

• Linearity Assumption: The method assumes a perfectly linear relationship between activity and cost. In reality, costs often exhibit non-linear behavior. For instance, costs might increase at a decreasing rate beyond a certain activity level due to economies of scale.

• Ignoring Other Data Points: The high-low method only uses two data points, ignoring all other available data. This can lead to inaccurate results, particularly if there's significant variation in the data.

• Potential for Error: Slight inaccuracies in the data can lead to significant errors in the calculated fixed and variable costs.

Alternatives to the High-Low Method

While the high-low method is easy to understand and apply, more sophisticated techniques exist for analyzing mixed costs, including:

• Regression Analysis: This statistical method uses all available data points to determine the fixed and variable costs, providing a more accurate estimate.

• Scattergraph Method: This visual method plots the cost and activity levels to identify the relationship between them, providing a visual representation of the cost behavior.

• Account Analysis: This method involves carefully examining each cost item to determine whether it's fixed or variable.

Improving the Accuracy of the High-Low Method

While it has limitations, the high-low method's simplicity can be advantageous. Here's how to improve its accuracy:

• Data Cleaning: Carefully examine the data for outliers and errors before applying the method.

• Multiple Data Sets: Instead of using only one pair of high and low data points, analyze data across several periods to identify consistent patterns. Average the results of multiple calculations to improve accuracy.

• Consider Seasonality: If costs vary significantly due to seasonal factors, analyze data for each season separately.

• Understand the Limitations: Acknowledge that the high-low method provides an estimation, not a precise result. Use it as a starting point, refining the results with other techniques or further analysis.

Conclusion: Understanding Fixed Costs in the High-Low Method

The high-low method provides a quick and easy way to estimate fixed and variable costs, providing valuable insights for cost management. However, it's critical to understand its limitations and use it judiciously. Remember that the fixed cost obtained using this method is an approximation of the fixed portion of the mixed cost being analyzed within the confines of the linear relationship assumption. While it can be a useful tool, especially for preliminary analysis or when data is limited, it’s advisable to use more robust methods like regression analysis for more precise results. Always consider the context and limitations of the method before making critical decisions based on its outcomes. By understanding these nuances and utilizing the suggested improvements, you can gain more valuable insights from this essential cost accounting tool.