High-Low Method: Learn How to Estimate Fixed & Variable Costs

The company wants to know the rate at which its electricity cost changes when the number of machine bom acct meaning hours change. The part of the electric bill that does not change with the number of machine hours is known as the fixed cost. 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.

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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. Calculating the outcome for the high-low method requires a few formula steps. First, you must calculate the variable-cost component and then the fixed-cost component, and then plug the results into the cost model formula. The high-low method is a straightforward, if not slightly lengthy, way to figure out your total costs. While the high-low method is an easy one to use, it also has its disadvantages.

1. But this is only if the variable cost is a fixed charge per unit of product and the fixed costs remain the same.
2. 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.
3. Due to its unreliability, high low method should be carefully used, usually in cases where the data is simple and not too scattered.
4. You need to know what the expected amount of overheads that your production line will incur in the next month.
5. While the high-low method is an easy one to use, it also has its disadvantages.

Step 3: Calculate the Fixed Cost

All of our content is based on objective analysis, and the opinions are our own. It’s also possible to draw incorrect conclusions by assuming that just because two sets of data correlate with each other, one must cause changes in the other. Regression analysis is also best performed using a spreadsheet program or statistics program. However, the formula does not take inflation into consideration and provides a very rough estimation because it only considers the extreme high and low values, and excludes the influence of any outliers. Let’s say that you are running a business producing high end technology products.

The change in the total costs is thus the variable cost rate times the change in the number of units of activity. Continuing with this example, if the total electricity cost was $18,000 when there were 120,000 MHs, the variable portion is assumed to have been $12,000 (120,000 MHs times $0.10). 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.

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You need to know what the expected amount of overheads that your production line will incur in the next month. There are a number of accounting techniques used throughout the business world. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

The cost amounts adjacent to these activity levels will be used in the high-low method, even though these cost amounts are not necessarily the highest and lowest costs for the year. The high low method is used in cost accounting as a method of separating a total cost into fixed and variable costs components. 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 is purchase return a debit or credit should be excluded before using high-low method. The high or low points used for the calculation may not represent the costs normally incurred at those volume levels due to outlier costs that are higher or lower than would normally be incurred. 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.

Let’s assume that the company is billed monthly for its electricity usage. 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).

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The high-low method is used to calculate the variable and fixed costs of a product or entity with mixed costs. It considers the total dollars of the mixed costs at the highest volume of activity and the total dollars of the mixed costs at the lowest volume of activity. The total amount of fixed costs is assumed to be the same at both points of activity.

This method can only be used if the scattergram that you used for your initial testing shows a linear correlation between the costs and the quantity! Also note that although this method is simple to apply it only uses the two points of data. Having only two points of data might produce results that are not accurate.