High low method

What Is the High-Low Method?

The high-low method is a straightforward technique used in managerial accounting to separate the fixed costs and variable costs components of a mixed cost. Mixed costs, also known as semi-variable costs, contain both a fixed portion that does not change with activity levels and a variable portion that fluctuates with the level of activity. This method simplifies the process of cost estimation by focusing solely on the highest and lowest activity levels within a given period to determine the per-unit variable cost and total fixed costs, offering a quick way to understand cost behavior.

History and Origin

The high-low method emerged as a practical tool within cost accounting to analyze and predict expenses. Its development is rooted in the need for businesses to understand how their costs behave in relation to production or service activity. Before advanced statistical software became widely accessible, simpler, manual methods were necessary for managers to derive insights for decision-making. Managerial accounting, as a discipline, focuses on providing internal information to aid management in planning and control. The high-low method became a foundational technique taught for cost analysis due to its computational simplicity, allowing for quick estimations of cost components, a critical step in understanding overall cost structures. Many foundational accounting texts introduce the high-low method as a primary approach to estimating a variable and fixed cost equation.⁹

Key Takeaways

• The high-low method isolates the variable and fixed components of a mixed cost.
• It uses only the highest and lowest activity levels and their corresponding total costs.
• The method is valued for its simplicity and ease of calculation, requiring minimal data.
• It provides a quick estimate for cost planning and basic budgeting.
• The high-low method is most reliable when cost behavior is linear within the relevant range.

Formula and Calculation

The high-low method involves a two-step calculation to determine the variable cost per unit and the total fixed costs.

Step 1: Calculate the Variable Cost per Unit

The variable cost per unit is found by dividing the change in total cost by the change in the activity level between the high and low points.

$\text{Variable Cost Per Unit} = \frac{\text{Highest Activity Cost} - \text{Lowest Activity Cost}}{\text{Highest Activity Level} - \text{Lowest Activity Level}}$

Step 2: Calculate Total Fixed Costs

Once the variable cost per unit is known, the total fixed costs can be determined by taking the total cost at either the high or low activity point and subtracting the total variable cost at that same point.

$\text{Total Fixed Costs} = \text{Total Cost at High Activity} - (\text{Variable Cost Per Unit} \times \text{Highest Activity Level})$

Or, alternatively:

$\text{Total Fixed Costs} = \text{Total Cost at Low Activity} - (\text{Variable Cost Per Unit} \times \text{Lowest Activity Level})$

The "activity level" refers to a measure that drives the cost, such as units produced, machine hours, or labor hours. The corresponding "cost" is the total mixed cost observed at that activity level.

Interpreting the High-Low Method

Interpreting the results of the high-low method provides insight into how a company's costs will behave at different production or service levels. The calculated variable cost per unit reveals the incremental cost incurred for each additional unit of activity. For instance, if the variable cost per unit of production is determined to be $5, managers know that producing one more unit will add $5 to total variable costs. The total fixed costs represent the expenses that remain constant regardless of the activity level within the defined relevant range, such as rent or salaries of administrative staff.

These estimated cost components are crucial for various managerial decisions. They enable a business to forecast costs for different production volumes, perform cost-volume-profit analysis, and prepare flexible budgets that adjust for changes in activity. For example, knowing the fixed and variable costs allows for the calculation of a product's contribution margin, which is vital for pricing decisions and profitability analysis.

Hypothetical Example

Consider a small manufacturing company, "Widgets Inc.," that produces a single type of widget. The company wants to estimate its mixed manufacturing overhead costs, which include utilities and maintenance. They collect the following data for the last six months:

Step 1: Identify High and Low Points

• Highest Activity Level: April, 12,000 units with a total mixed cost of $42,000.
• Lowest Activity Level: May, 6,000 units with a total mixed cost of $30,000.

Step 2: Calculate Variable Cost per Unit

$\text{Variable Cost Per Unit} = \frac{\$42,000 - \$30,000}{12,000 \text{ units} - 6,000 \text{ units}} = \frac{\$12,000}{6,000 \text{ units}} = \$2 \text{ per unit}$

Step 3: Calculate Total Fixed Costs

Using the high activity point:

$\text{Total Fixed Costs} = \$42,000 - (\$2 \text{ per unit} \times 12,000 \text{ units}) = \$42,000 - \$24,000 = \$18,000$

Alternatively, using the low activity point:

$\text{Total Fixed Costs} = \$30,000 - (\$2 \text{ per unit} \times 6,000 \text{ units}) = \$30,000 - \$12,000 = \$18,000$

The estimated cost equation for Widgets Inc.'s manufacturing overhead is: Total Mixed Cost = $18,000 (Fixed) + $2 (Variable per unit) (\times) Units Produced. This equation allows Widgets Inc. to predict its total mixed costs at different activity levels.

Practical Applications

The high-low method finds practical application in various areas of business and financial analysis, particularly where a quick estimate of cost behavior is needed. Businesses often use it for preliminary cost analyses to inform pricing strategies, especially when setting prices for new products or services. By separating fixed and variable components, companies can better understand the cost implications of changes in sales volume, which directly impacts their profitability.

Furthermore, the high-low method can assist in preparing internal budgets and conducting what-if scenarios, such as how changes in production volume might affect total costs and, subsequently, net income. While not as precise as more sophisticated methods, its simplicity makes it accessible for small businesses or for initial analyses before committing resources to more complex studies. Effective cost management is crucial for maintaining a competitive advantage and enhancing profitability, prompting companies to constantly review and reduce their operational costs where possible.⁸ Techniques like the high-low method provide a foundational approach to initiating such cost reduction efforts by offering clarity on cost structures. Efforts to reduce costs and improve operational efficiency are also seen in broader business methodologies like Lean Six Sigma, which emphasizes data-driven improvements across various sectors.⁷

Limitations and Criticisms

Despite its simplicity, the high-low method has notable limitations that can lead to inaccurate cost predictions. A primary criticism is that it relies solely on two data points—the highest and lowest activity levels. T⁶hese two points may not be representative of the typical cost behavior across the entire range of operations, especially if they are outliers or anomalies. For example, a single unusual event at the highest or lowest activity level could significantly distort the estimated variable and fixed costs.

⁵The method also assumes a linear relationship between cost and activity, meaning costs increase or decrease consistently per unit of activity. However, in reality, cost behavior can be non-linear due to economies of scale, volume discounts, or step costs that change abruptly at certain thresholds outside the relevant range., ⁴U³nlike graphical methods like a scatter plot or statistical techniques such as regression analysis, the high-low method does not consider all available data points, making it less robust and potentially less accurate for complex cost structures. T²hese inherent assumptions and reliance on limited data points mean the high-low method provides a rough estimate rather than a precise measure of cost behavior.

¹## High-Low Method vs. Regression Analysis

The high-low method and regression analysis are both techniques used for cost estimation, but they differ significantly in their complexity, data utilization, and resulting accuracy.

The high-low method, as discussed, is a manual, simplistic approach that calculates variable and fixed costs using only the two extreme data points (highest and lowest activity levels) within a period. It's quick to apply and requires no statistical software, making it accessible for quick, back-of-the-envelope calculations. However, its reliance on just two points makes it highly susceptible to distortions caused by unusual or unrepresentative observations at those extremes.

In contrast, regression analysis is a statistical method that considers all available data points to find the "line of best fit" through them. This line minimizes the sum of the squared distances from each data point to the line, providing a more statistically sound and objective estimate of variable and fixed costs. Regression analysis yields coefficients (like R-squared) that indicate the goodness of fit, allowing analysts to assess the reliability of the cost equation. While more complex and requiring statistical software, regression analysis typically provides a more accurate and reliable cost estimation, making it the preferred method for robust financial forecasting and decision-making when sufficient data is available.

FAQs

Q1: When is the high-low method most useful?

The high-low method is most useful when a quick, rough estimate of fixed and variable costs is needed, often as a preliminary step in cost analysis or when more sophisticated methods are impractical due to time or data constraints.

Q2: Can the high-low method be used for all types of costs?

The high-low method is specifically designed for mixed costs—those that have both fixed and variable components. It is not applied to purely fixed or purely variable costs, as their behavior is already known.

Q3: What is the "relevant range" in the context of the high-low method?

The relevant range refers to the range of activity over which the assumed linear relationship between cost and activity is valid. The high-low method's estimates are only considered reliable within this range, as cost behavior can change significantly outside of it due to different operational conditions or resource capacities.