High low method uses the lowest production quantity and the highest production quantity and comparing the total cost at each production level. It uses only the lowest and highest production activities to estimate the variable and fixed cost, by assuming the production quantity and cost increase in linear. It ignores the other points of productions, so it may be an error when the cost does not increase in a linear graph.

Its drawback, however, is that not all data points are considered in the analysis. Other methods such as the scatter-graph method and linear regression address this flaw. This fixed cost remains market value of an asset consistent regardless of the number of units produced. However, suppose both levels of activities remain under the threshold of customarily fixed cost. In that case, there is no need to consider step fixed cost in calculating the high low method.

High-Low Method vs Regression Analysis

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). In other words, the variable cost rate was $0.10 per machine hour ($2,000/20,000 MHs).

However, the company needs to produce 15,000 units in some particular month. Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable and fixed costs, we have total and fixed costs. The fixed cost can then be calculated at the specific activity level i.e. either high level or low level of activity. Let’s assume that the company is billed monthly for its electricity usage.

Step 01: Determine the highest and lowest level of activities and units produced

The high-low method can also be done mathematically for accurate computation. Another drawback of the high-low method is the ready availability of better cost estimation tools. For example, the least-squares regression is a method that takes into consideration all data points and creates an optimized cost estimate. It can be easily and quickly used to yield significantly better estimates than the high-low method. Given the dataset below, develop a cost model and predict the costs that will be incurred in September. Understanding the high low method can be crucial for your business, allowing for efficient cost management and strategic planning for various levels of production.

C. Calculate Fixed Costs

Due to the simplicity of using the high-low method to gain insight into the cost-activity relationship, it does not consider small details such as variation in costs. The high-low method assumes that fixed and unit variable costs are constant, which is not the case in real life. Because it uses only two data values in its calculation, variations in costs are not captured in the estimate. Regression analysis helps forecast costs as well, by comparing the influence of one predictive variable upon another value or criteria. However, regression analysis is only as good as the set of data points used, and the results suffer when the data set is incomplete. The division of differential cost with the differential level of activity results in the variable cost per unit.

High low method is the mathematical method that cost accountant uses to separate fixed and variable cost from mixed cost. We use the high low method when the cost cannot clearly separate due to its nature. Mixed cost is the combination of variable and fixed cost and it is also called “Semi Variable Cost”. The manager of a hotel would like to develop a cost model to predict the future costs of running the hotel. Unfortunately, the only available data is the level of activity (number of guests) in a given month and the total costs incurred in each month. Being a new hire at the company, the manager assigns you the task of anticipating the costs that would be incurred in the following month (September).

So, the differential cost of USD 10,000 divided by differential units of 4,000 results in USD 2.5 per unit (10,000/4,000). Similarly, the variable cost of producing 10,000 units has been deducted from the total cost of USD 55,000 at the higher level of activity. Hence, the remaining balance of the numerator is the variable cost of differential 4,000 units. Hence, when we deduct USD 45,000 in USD 55,000, the fixed cost is net and the variable cost to the extent of equality in the level of production is eliminated.

The high-low method helps organizations break down mixed costs into fixed and variable components, offering a clearer understanding of cost behavior relative to activity levels. This understanding is essential for predicting how costs will change with varying production or service levels, aiding in budgeting and financial planning. 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 an accounting technique used to estimate the fixed and variable cost of production in businesses. This approach is valuable in cost accounting as it examines and compares the total costs at the highest and lowest levels of activity.

• Such a cost function may be used in budgeting to estimate the total cost at any given level of activity, assuming that past performance can reasonably be projected into future.
• By substituting the amounts in the cost equation of the lowest point, we can determine the fixed cost (a).
• This fixed cost remains consistent regardless of the number of units produced.
• The first step is to determine the highest and lowest levels of activities and the units produced against each of these levels.

One has to consider step fixed cost/additional fixed cost to come up with the full fixed cost. So, to produce additional 5,000 units, the company has to extend their production facility, which is expected to incur the cost same as the previous facility of 10,000 units. Hence, once the limit of normal production capacity is reached, the company has to incur another fixed cost irrespective of additional units to be produced.

• If the variable cost is a fixed charge per unit and fixed costs remain the same, it is possible to determine the fixed and variable costs by solving the system of equations.
• Highest activity level is 21,000 hours in Q4.Lowest activity level is 15,000 hours in Q1.
• The cost of lower activity is deducted from the cost of higher activity and the resultant is written in the numerator.
• When analyzing costs as to behavior, costs are classified into fixed and variable costs.
• He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries.

Form the Cost Equation

By breaking down mixed costs, companies can ensure compliance with tax regulations and better understand deductible expenses, impacting their effective tax rate and overall financial health. This method also supports accountants in refining financial projections and tax strategies, ensuring alignment with statutory requirements. High Low Method provides an easy way to split fixed and variable components of combined costs using the following formula. By substituting the amounts in the cost equation of the lowest point, we can determine the fixed cost (a). The company plans to produce 7,000 units in March 2019 on the back of buoyant market demand.

In other words, as fixed cost is the same in both months, the fixed cost has been eliminated by deduction. Hence, the difference in total costs in both months is due to the difference in product level. Simply adding what’s your preferred federal income tax filing vendor the fixed cost (Step 3) and variable cost (Step 4) gives us the total cost of factory overheads in April. Although easy to understand, high low method may be unreliable because it ignores all the data except for the two extremes. It can be argued that activity-cost pairs (i.e. activity level and the corresponding total cost) which are not representative of the set of data should be excluded before using high-low method.

Before costs can be effectively used in analysis, they should be segregated into purely fixed and purely variable costs. Given the variable cost per number of guests, we can now determine our fixed costs. Calculating the outcome for the high-low method requires a few formula steps.

The cost of lower activity is deducted from the cost of higher activity and the resultant is written in the numerator. Similarly, a low level of production is deducted from a higher level of production and placed in the denominator. In other words, a difference in the cost is closing entry definition divided by the difference in the level of production. The high-low method can be done graphically by plotting and connecting the lowest point of activity and the highest point of activity. The y-intercept (value of y when x is zero) would be equal to the fixed cost.

Data x represents the number of units while y represents the corresponding cost. Take your learning and productivity to the next level with our Premium Templates. The following are the given data for the calculation of the high-low method. For example, the table below depicts the activity for a cake bakery for each of the 12 months of a given year.

It is a nominal difference, and choosing either fixed cost for our cost model will suffice. The high-low method is a simple analysis that takes less calculation work. It only requires the high and low points of the data and can be worked through with a simple calculator. The final step in the high low method is to calculate the fixed cost component. The high-low method offers a practical solution for addressing mixed costs, simplifying financial reporting.