What Is the High-Low Method and How Is It Used in Accounting?

Once these points are determined, they serve as the basis for the entire cost estimation process. The difference in total costs between the high and low points is assumed to be entirely due to the variable costs, as fixed costs remain unchanged. It involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level. If the variable cost is a fixed charge per unit and fixed costs remain the same, it is possible to work out the fixed and variable costs by solving the equations.

Steps to Perform the High-Low Method

The high low method is a cost accounting technique that separates mixed costs into fixed and variable components using the highest and lowest activity levels. It’s best used for quick estimates when detailed analysis isn’t required or when data is limited. Least squares regression is a statistical method used to determine the line of best fit through a set of data points on a scatter plot.

• This scenario best shows that there will be instances where the cost equation won’t hold true.
• By understanding the high low method, financial analysts and managers can make more informed decisions about pricing, production planning, and cost control.
• Regression analysis is generally considered more reliable because it incorporates all data points, reducing the impact of anomalies.
• The scatter plot method is particularly useful when preliminary insights are needed before applying more complex statistical techniques.
• However, it provides reasonable approximations when cost behavior is relatively linear and the data points are representative.

The y-intercept (value of y when x is zero) would be equal to the fixed cost. The high-low method can also be done mathematically for accurate computation. By using the formula in computing the variable cost per unit, let’s substitute the figures we gathered from Step 1. Follow the steps below to perform the high-low method by using our dividends payable definition + journal entry examples sample data from Fusion Company. Let’s assume that the company wants to project client support costs for next year’s budgeting.

Variable Cost

Unlike regression analysis, the high low method provides no statistical measures to assess the reliability of the results. There are no confidence intervals, correlation coefficients, or other statistics to validate the findings. The high-low method may produce inaccurate results since it only considers two extreme data points, which may not be representative of other data points.

The recent experience with U.S. tariffs on China has demonstrated that tariff passthrough to retail prices was low (Cavallo et al, 2021). As an example of how to calculate high low method, suppose a business had the following information relating to its a guide to basic accounting principles costs. In our previous dog groomer example we could clearly see through our scattergram that maintenance costs were related to the number of dogs groomed.

Insights Revealed by the High-Low Method

When choosing the extreme values, consider the units produced, services rendered, or any other relevant activity measure. The highest activity level represents the point where production or activity is at its peak, while the lowest activity level represents the minimum production or activity level. In the context of cost analysis, it is crucial to distinguish between fixed and variable costs.

For example, a retail company experiencing seasonal sales fluctuations can use this method to forecast costs more accurately and allocate resources efficiently. The high-low method is a straightforward approach used in accounting to separate fixed and variable costs within mixed cost structures. By analyzing the relationship between cost behavior and activity levels, it provides valuable insights for budgeting, forecasting, and decision-making. Identifying the variable cost per unit and the fixed cost component helps businesses understand how costs change with activity levels. This information assists in pricing decisions, budgeting, and evaluating the financial impact of different scenarios.

Costs within a business are typically categorized as either variable or fixed. For example, the cost of raw materials would increase as more products are manufactured. Conversely, fixed costs remain constant regardless of the business’s output level. Rent or salaries are often cited as fixed costs because they do not fluctuate with production volume. The method works on the basis that the variable cost per unit and the fixed costs are assumed not to change throughout the range of the two values used.

High Low Method Formula

While the high low method can be applied to most businesses with mixed costs, it works best in operations where cost behavior is relatively stable and linear. Industries with highly variable or step-function costs may find the method less reliable. These calculations form the foundation of the high low method explained in practical terms. By isolating these cost components, businesses can better understand their cost structures and make more informed financial decisions.

While it is easy to apply, it can distort costs and yield more or less accurate results because of its reliance on two extreme values from one data set. Contact us at CFO Consultants LLC to discover how we can help you grow your business by optimizing your cost estimation processes. Remember, informed decision-making in business starts with accurate cost estimation. The high-low method can be done graphically by plotting and connecting the lowest point of activity and the highest point of activity.

Step 1: Determine the Highest and Lowest Activity Levels

Eric Gerard Ruiz, a licensed CPA in the Philippines, specializes in financial accounting and reporting (IFRS), managerial accounting, and cost accounting. He has tested and review accounting software like QuickBooks and Xero, along with other small business tools. Eric also creates free accounting resources, including manuals, spreadsheet trackers, and templates, to support small business owners. But more importantly, this scenario shows the weakness of the high-low method.

This tool fasb’s new standard for classifying deferred taxes can help you understand the business’ cost structure and aid in rational decision-making. However, it can produce less accurate and unreliable results since it only uses two extreme data points. Assume that the cost of electricity at a small manufacturing facility is a mixed cost since the company has only one electricity meter for air quality, cooling, lighting, and for its production equipment.

Sensitivity to Data Selection

• The high low method is used in cost accounting as a method of separating a total cost into fixed and variable costs components.
• The hi low method now takes the highest and lowest activity cost values and looks at the change in total cost compared to the change in units between these two values.
• By isolating these cost components, businesses can better understand their cost structures and make more informed financial decisions.
• With the variable cost per unit determined in Step 2, we can work backward to find the fixed cost.
• If either the highest or lowest data point is an anomaly or outlier, the entire analysis becomes skewed.
• It is possible for the analysts and accountants to use this method effectively for determining both the fixed and variable cost component.
• It helps businesses understand cost structure, predict costs at different activity levels, and optimize resource allocation.

In cost accounting, the high-low method is a way of attempting to separate out fixed and variable costs given a limited amount of data. The high-low method involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level. To calculate the variable cost using the High-Low Method, subtract the fixed cost component from the total cost at either the highest or lowest activity level. The High-Low Method resolves the problem of separating fixed and variable costs within a total cost amount. It allows businesses to estimate these cost components, providing valuable insights into cost behavior and aiding decision-making.

Practical Example of High-Low Method: Cost Estimation for Producing 350 Units

Since the total electricity cost was $18,000 and the variable cost was calculated to be $12,000, the fixed cost of electricity for the month must have been the $6,000. If we use the lowest level of activity, the total cost of $16,000 would include $10,000 of variable cost (100,000 MHs times $0.10) with the remainder of $6,000 being the fixed cost for the month. The hi low method now takes the highest and lowest activity cost values and looks at the change in total cost compared to the change in units between these two values. Assuming the fixed cost is actually fixed, the change in cost must be due to the variable cost.

The cost of electricity was $18,000 in the month when its highest activity was 120,000 machine hours (MHs). (Be sure to use the MHs that occurred between the meter reading dates appearing on the bill.) The cost of electricity was $16,000 in the month when its lowest activity was 100,000 MHs. This shows that the total monthly cost of electricity changed by $2,000 ($18,000 vs. $16,000) when the number of MHs changed by 20,000 (120,000 vs. 100,000).

Multiply the variable cost per unit (step 2) by the number of units expected to be produced in May to work out the total variable cost for the month. Now that we have this figure, let’s proceed to Step 3 to determine the total fixed cost. Discover how the high-low method simplifies cost analysis in accounting by estimating variable and fixed costs for better financial decision-making.

This leads to more informed decisions that enhance operational efficiency and profitability. The fixed cost can be calculated once the variable cost per unit is determined. The high-low method’s utility extends into the strategic sphere of decision making, where it informs leaders on cost behavior for various scenarios. By distinguishing between fixed and variable costs, decision-makers can predict how changes in production levels or service delivery might impact overall costs. This insight is particularly useful when evaluating the financial implications of strategic decisions such as expanding operations, introducing new product lines, or entering new markets. While the high-low method offers a simplified approach to cost estimation, it is not the only technique available to businesses.