While some costs are purely variable and some fixed, there are mixed costs that contain both variable and fixed elements. The High-Low Method is a technique that you can use in order to isolate the variable and fixed components of a mixed cost.
Definition of High-Low Method
The high-low method is a cost accounting technique that can be used to separate variable and fixed elements of a semivariable cost. This mathematical technique involves taking the highest activity level and the lowest activity level from a given set of data and comparing the total costs at each activity level to determine or predict costs at various activity levels.
Simply put, if you want to know how much cost is fixed and how much is variable for a business, you can segregate the fixed and variable elements using the high-low method in order to break down the cost.
Though considered a relatively unsophisticated method, the high-low method is still practiced by a vast majority of businesses for splitting semivariable costs mainly because it is easier to apply and needs no advanced accounting or mathematical knowledge.
The High-low method is also applied to predict costs at different activity levels. For example, if we have the data of costs at different activity levels available, then using the high-low method, we can determine how much it would cost to produce a certain number of units.
How to Calculate the High-Low Method?
The high-low method calculation involves a few simple steps. In order to use the high-low method, you need to have the following data:
- Activity Levels such as the number of units produced
- Costs incurred
Typically, you will see this data in a tabular form given below.
| Month | Units Produced | Costs ($) |
|---|---|---|
| January | 860 | 135,000 |
| February | 780 | 124,000 |
| March | 870 | 136,000 |
| April | 900 | 141,000 |
| May | 960 | 148,000 |
Now, to calculate the variable and fixed costs using the high-low method, you can follow the following 3 simple steps:
Step 1: Identify the highest and lowest activity level
In the above example, the highest activity level is 960 units and the lowest activity level is 780 units. The costs incurred are $148,000 and $124,000 respectively.
Step 2: Calculate variable cost per unit using the following equation
In order to calculate the variable cost per unit, you need to use the following equation:
(Highest Activity Level – Lowest Activity Level) ÷ (Highest Units – Lowest Units)
Putting values we get; (148,000-124,000) ÷ (960-780)
Variable cost per unit = 133
Step 3: Calculate Fixed Costs
You can calculate the fixed costs using either the data of the lowest activity level or the highest activity level. Let us consider the highest activity level first. Here’s how you can calculate the fixed costs in the high-low method:
Highest Activity Costs – (variable cost per unit * highest activity units)
Putting values we get; 148,000 – (133 * 960)
Fixed Costs = $20,320
Related read: Fixed and Step-Fixed Costs
This data can be used to predict the future costs of the business. For example, if the business is to produce 1200 units next month then you can calculate the costs for 1200 units as follows:
Variable costs= $159,600 (133*1200)
Fixed Costs = $20,320
Total costs for 1200 units = $179,920 (159,600 + 20,320)
Advantages & Disadvantages Of Using The High-Low Method
Pros
- The high-low method is simple and easy to use.
- It is easy to understand and explain, making it suitable for small businesses and entrepreneurs.
- It eliminates the need for complex mathematical calculations, saving time and effort.
- It can provide a basic understanding of cost behavior and cost structures.
- It helps identify trends in costs and can be used to predict future costs.
Cons
- It does not take into consideration any changes in the cost structure such as changes to production volume, or materials and labor costs over time.
- It cannot be applied to all cost types as some costs may not have clearly identifiable variable and fixed components.
- It is not suitable for cost allocation purposes.
- It is not suitable for companies with multiple cost centers.
- It is not suitable for complex cost structures.
Why The High-Low Method Is Popular?
The high-low method is popular because it is a simple and cost-effective way to calculate the fixed and variable costs of a business. It is easy to understand and explain, making it suitable for small businesses and entrepreneurs. The high-low method eliminates the need for complex mathematical calculations, saving time and effort.
It can provide a basic understanding of cost behavior and cost structures and helps identify trends in costs that can be used to predict future costs. It is also useful for budgeting and forecasting.
Alternatives Of The High-Low Method
There are other techniques that are closely related to the high-low method. Though these techniques do not replace the high-low method since each technique analyses cost in a different way. Here are some alternatives of the high-low method in cost accounting:
- Regression Analysis: This is a statistical method used to analyze the relationship between two or more variables. It can be used to predict the cost behavior of a business over time.
- Activity-Based Costing: This is a method used to assign costs to specific activities. It can be used to identify the costs associated with each activity and then allocate them to the products or services produced.
- Cost-Volume-Profit Analysis (CVP): This is a method used to analyze the relationship between costs, sales volume, and profits. It can be used to determine how changes in costs and sales volume will affect profits.
- Target Costing: This is a method used to control costs by setting target costs and then controlling costs to meet the targets. It can be used to reduce costs while ensuring products meet customer requirements.
Is The High-Low Method Suitable For Small or Large Businesses?
The high-low method is suitable for both small and large businesses. It is a simple and cost-effective way to calculate the fixed and variable costs of a business. It is easy to understand and explain, making it suitable for small businesses and entrepreneurs.
Additionally, it can provide a basic understanding of cost behavior and cost structures, and helps identify trends in costs that can be used to predict future costs. For larger businesses, the high-low method can help to identify cost drivers and can be used to inform budgeting and forecasting.
Article Sources
https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1468-5957.1977.tb00726.x
