The High Low Method: How to Split Variable and Fixed Costs

The high low method uses a small amount of data to separate fixed and variable costs. It takes the highest and lowest activity levels and compares their total costs. On the other hand, regression analysis shows the relationship between two or more variables. It is used to observe changes in the dependent variable relative to changes in the independent variable. The cost accounting technique of the high-low method is used to split the variable and fixed costs.

It uses this comparison to estimate the fixed cost, variable cost, and a cost function for finding the total cost of different production units. The manager of a hotel would like to develop a cost model to predict the future costs of running the hotel. Unfortunately, the only https://intuit-payroll.org/ 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).

Now, the Beach Inn can apply the cost equation in order to forecast total costs for any number of nights, within the relevant range. 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. Simply adding the fixed cost (Step 3) and variable cost (Step 4) gives us the total cost of factory overheads in April. Always select the period with the highest activity level and the period with the lowest activity level. As you can see from the scatter graph, there is really not a linear relationship between how many flight hours are flown and the costs of snow removal.

The high-low accounting method estimates these costs for different production levels, mainly if you have limited data to inform your decisions. This article describes the high-low method formula and how to use the high-low cost method calculator to estimate any business or production cost per unit. There is a step up of $5,000 in fixed costs when activity crosses 35,000 units.

1. It is important to remember here that it is the highest and lowest activity levels that need to be identified first rather than the highest/lowest cost.
2. By only requiring two data values and some algebra, cost accountants can quickly and easily determine information about cost behavior.
3. We can calculate the variable cost and fixed cost components by using the High-Low method.
4. The high-low method only requires the cost and unit information at the highest and lowest activity level to get the required information.

Estimation is also useful for using current data to predict the effects of future changes in production on total costs. Three estimation techniques that can be used include the scatter graph, the high-low method, and regression analysis. Here we will demonstrate the scatter graph and the high-low methods (you will learn the regression analysis technique in advanced managerial accounting courses. A scatter graph shows plots of points that represent actual costs incurred for various levels of activity.

Demonstration of the High-Low Method to Calculate Future Costs at Varying Activity Levels

The what are the tax brackets can be used to identify these patterns and can split the portions of variable and fixed costs. Simply multiplying the variable cost per unit (Step 2) by the number of units expected to be produced in April gives us the total variable cost for that month. It is important to remember here that it is the highest and lowest activity levels that need to be identified first rather than the highest/lowest cost.

The high-low method only requires the cost and unit information at the highest and lowest activity level to get the required information. Managers can implement this technique with ease since it does not require any special tools. Waymaker Furniture has collected cost information from its production process and now wants to predict costs for various levels of activity. This is the case for the managers at the Beach Inn, a small hotel on the coast of South Carolina. They know what their costs were for June, but now they want to predict their costs for July.

High-low method formula

Once the scatter graph is constructed, we draw a line (often referred to as a trend line) that appears to best fit the pattern of dots. When interpreting a scatter graph, it is important to remember that different people would likely draw different lines, which would lead to different estimations of fixed and variable costs. No one person’s line and cost estimates would necessarily be right or wrong compared to another; they would just be different. The Total cost refers to a summation of the fixed and variable costs of production. Suppose the variable cost per unit is fixed, and fixed costs at the highest and lowest production levels remain the same.

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

Maintenance costs are plotted on the vertical axis (Y), while flight hours are plotted on the horizontal axis (X). For instance, one point will represent 21,000 hours and $84,000 in costs. The next point on the graph will represent 23,000 hours and $90,000 in costs, and so forth, until all of the pairs of data have been plotted. Finally, a trend line is added to the chart in order to assist managers in seeing if there is a positive, negative, or zero relationship between the activity level and cost. In all three examples, managers used cost data they have collected to forecast future costs at various activity levels.

The first step in analyzing mixed costs with the high-low method is to identify the periods with the highest and lowest levels of activity. We always choose the highest and lowest activity and the costs that correspond with those levels of activity, even if they are not the highest and lowest costs. Using this information and the cost equation, predict Waymaker’s total costs for the levels of production in Table 2.12. 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.

The highest activity level is 18,000 in Q4, and the lowest activity level is 10,000 in Q1. 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. Using either the high or low activity cost should yield approximately the same fixed cost value. Note that our fixed cost differs by $6.35 depending on whether we use the high or low activity cost. It is a nominal difference, and choosing either fixed cost for our cost model will suffice.

How to Use the High Low Method to Estimate Fixed and Variable Costs?

The high low method can be relatively accurate if the highest and lowest activity levels are representative of the overall cost behavior of the company. However, if the two extreme activity levels are systematically different, then the high low method will produce inaccurate results. The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost ÷ change in number of units produced). Once we have arrived at variable costs, we can find the total variable cost for both activities and subtract that value from the corresponding total cost to find a fixed cost.

In cost accounting, the high-low method is a technique used to split mixed costs into fixed and variable costs. Although the high-low method is easy to apply, it is seldom used because it can distort costs, due to its reliance on two extreme values from a given data set. Where Y is the total mixed cost, a is the fixed cost, b is the variable cost per unit, and x is the level of activity.

In that case, the high-low method calculator applies the high-low method formula to evaluate the total costs at any given amount of production. You can then use these estimates in preparing your budgets or analyzing an expected monetary value for a contingency reserve. The high-low method is used to calculate the variable and fixed cost of a product or entity with mixed costs.

For complex scenarios, alternate methods should be considered such as scatter-graph method and least-squares regression method. For example, the table below depicts the activity for a cake bakery for each of the 12 months of a given year.

This makes sense as snow removal costs are linked to the amount of snow and the number of flights taking off and landing but not to how many hours the planes fly. To demonstrate how a company would use a scatter graph, let’s turn to the data for Regent Airlines, which operates a fleet of regional jets serving the northeast United States. The Federal Aviation Administration establishes guidelines for routine aircraft maintenance based upon the number of flight hours. As a result, Regent finds that its maintenance costs vary from month to month with the number of flight hours, as depicted in Figure 2.29. J&L can now use this predicted total cost figure of $11,750 to make decisions regarding how much to charge clients or how much cash they need to cover expenses.

Given the dataset below, develop a cost model and predict the costs that will be incurred in September. So the highest activity happened in the month of Jun, and the lowest was in the month of March. So the highest activity happened in the month of April, and the lowest was in the month of October. In March, Waymaker produced 1,000 units and used 2,000 hours of production labor. Highest activity level is 21,000 hours in Q4.Lowest activity level is 15,000 hours in Q1.