There are three categories of costs in any business: fixed costs, variable costs, and mixed costs (mix of fixed and variable). In layman’s terms, the high low method in accounting is a method for separating fixed and variable costs from overall costs. It analyzes the highest and lowest levels of activity and then compares the cost at each level. This is a critical topic in cost accounting and is extremely valuable in determining fixed and variable costs associated with a product, machinery, and so on. In this article, we’ll learn how to utilize the high low method and formula in accounting and an example of the calculations.
What is the High-Low Method Accounting?
High-low method is used in accounting to separate fixed and variable cost elements from historical cost, which is a mixture of both fixed and variable costs. The high-low method accounting formula is used to calculate per unit variable cost by subtracting the cost of the lowest activity from the cost of the highest activity and dividing the resultant amount by the difference between units of highest activity and units of lowest activity.
The high-low method is a mathematical methodology used in cost accounting to separate fixed and variable components that are otherwise part of a mixed historical cost, i.e., partially fixed and partially variable. It involves determining the highest and lowest levels of activity and comparing the overall expenditures at each level.
High-Low Method Accounting Formula
The variable cost per unit is calculated using the high-low method by first subtracting the lowest activity cost from the highest activity cost, then subtracting the number of units at the lowest activity from the number of units at the highest activity, and finally dividing the former by the latter. It is expressed mathematically as,
Variable Unit Cost = (Highest Activity Cost – Lowest Activity Cost) / (Highest Activity Units – Lowest Activity Units)
High-low Method accounting formula
Once the variable cost per unit is determined,
Variable Unit Cost
Variable cost per unit refers to the cost of producing each unit, which varies as output volume or activity level increases. These are not committed costs because they arise only if the company is producing. Once the read more is determined, the fixed cost may be computed. It is computed by subtracting the product of variable cost per unit and the highest activity units from the highest activity cost or the product of variable cost per unit and the lowest activity units from the lowest activity cost.
It is expressed mathematically as,
Highest activity cost = Fixed cost – (Variable cost per unit * Highest activity units)
or
Lowest activity cost = Fixed cost – (Variable cost per unit * Lowest activity units)
Variable Cost vs. Fixed Cost
A fixed cost is a recurring expense that is not affected by the amount of units produced, such as rent payable, salaries payable, and other utilities payable. Variable costs are those that vary with production, such as direct materials and direct labor. The high-low method is derived by doing the following steps:
- First, use the available costing chart to determine the greatest and lowest activity units.
- Determine the proportional cost of production at the highest and lowest level activity units.
- Next, subtract the lowest activity cost from the highest activity cost to remove the fixed cost component, leaving only the variable component corresponding to the incremental number of units.
Highest activity cost – Lowest activity cost = variable cost component
- The incremental number of units is then computed by subtracting the number of units at the lowest activity from the number of units at the maximum activity.
Number of incremental units = Highest activity units – Lowest activity units
The variable cost per unit is then computed by dividing the expression from step 3 by the expression from step 4, as shown above.
Following that, the fixed cost is computed by subtracting the product of variable cost per unit and highest activity units from the highest activity cost, or by subtracting the product of variable cost per unit and lowest activity units from the lowest activity cost, as illustrated above.
Following that, the fixed cost is computed by subtracting the product of variable cost per unit and highest activity units from the highest activity cost, or by subtracting the product of variable cost per unit and lowest activity units from the lowest activity cost, as illustrated above.
High-Low Method Accounting Example
Let us look at an example to better understand the high low method accounting calculation.
The table below depicts a company’s overall cost for various production levels during the first six months of the year.
Production levels in the first six months of a year.
| Units | Total Cost |
| 3000 | $59,000 |
| 2720 | $55,000 |
| 2500 | $52,500 |
| 2150 | $50,500 |
| 1950 | $47,500 |
| 1250 | $38,000 |
To determine the fixed and variable costs, we must first compute the variable cost per unit using the aforementioned formula. In this case, x2 is 3000 and y2 is $59,000, while x1 is 1250 and y1 is $38,000.
Using the following variables in the formula: ($59,000 − $38,000) ÷ (3,000 − 1,250), we get a variable cost of $12 per unit.
Let’s figure out the fixed cost immediately. Incorporating the value into the formula:
The fixed cost will be $59,000 ($12,300) or $38,000 ($12,250). As a result, the fixed cost is $23,000.
We can frame the cost volume function now that we have both fixed and variable costs. It will be as follows: y = $23,000 + 12x
Relevance and Applications of High-Low Method In Accounting
It is critical to understand the high-low method since it is commonly employed in the formulation of corporate budgets. It is used to estimate the projected total cost at any given level of activity under the assumption that past performance may be practically extrapolated to future project costs. The method’s core principle is that the change in total costs is equal to the variable cost rate multiplied by the change in the number of units of activity.
However, it has disadvantages, such as the high-low method’s assumption of a linear relationship.
Linear Relationship
A linear relationship is a graph that depicts the relationship between two separate variables – x and y – as a straight line. When displaying a linear relationship in the form of an equation, the value of y is derived from the value of x, indicating their association. More reading between cost and activity, which may be an oversimplification of cost behavior. Furthermore, while the technique is simple, the high-low method is not deemed dependable because it ignores all data save the two extremes.
Benefits of the High-Low Method In Accounting
The high-low method is a simple way to separate fixed and variable costs. Cost accountants can rapidly and readily determine information about cost trends by requiring only two data values and basic algebra. Furthermore, the high-low method does not make use of or necessitate the usage of any complicated tools or programs.
High-Low Method In Accounting Drawbacks
Because of the ease with which the high-low method can be used to get insight into the cost-activity relationship, it does not take into account minor aspects such as cost variance. The high-low method presupposes constant fixed and unit variable expenses, which is not the case in real life. Variations in costs are not included in the estimate because it only employs two data values in its calculation.
Another disadvantage of the high-low method is the readily available availability of more accurate cost estimation tools. For example, least-squares regression is a method that considers all data points and generates an optimum cost estimate. It may be used quickly and easily to produce substantially better estimates than the high-low method.
What Is the Distinction Between the High-Low Method and Regression Analysis In Accounting?
The high-low method is a straightforward analysis that requires little calculation. It simply requires the data’s high and low points and maybe worked out using a simple calculator. It also allows analysts to forecast future unit costs. However, because it only analyzes the extreme high and low numbers and removes the influence of any outliers, the formula does not take inflation into account and produces a very imprecise estimate.
Regression analysis also aids in cost forecasting by analyzing the influence of one predictive variable on another value or criterion.
It also takes into account outlier numbers to assist refine the results. However, regression analysis is only as good as the collection of data points employed, and when the data set is inadequate, the findings deteriorate.
It is also possible to reach false conclusions by believing that because two sets of data correlate, one must cause changes in the other. Regression analysis is also best done with a spreadsheet or statistics tool.
High-Low Method In Accounting Limitations
Because it only considers two extreme activity levels, the high-low method is relatively unreliable. Due to outlier costs that are more or lower than would ordinarily be incurred, the high or low values considered for the computation may not be representative of the expenses normally incurred at that volume level. The high-low method will yield erroneous results in this scenario.
The high-low method is generally not favored because it can result in an erroneous comprehension of the data if the variable or fixed cost rates vary over time or if a tiered pricing system is used. In most real-world scenarios, additional information should be available to determine variable and fixed costs directly. As a result, the high-low method should be utilized only when actual billing data cannot be obtained.
Conclusion
The high-low method of accounting is uncomplicated and simple to apply. It also simplifies the work when comprehensive stage-by-stage cost data is unavailable. However, as previously stated, it does not provide particularly reliable results due to its two extreme data points. As a result, you should not rely only on this data to determine the true variable and fixed costs. It is beneficial if you need a rapid estimate of variable and fixed costs. However, don’t rely fully on it for accurate findings, as semi-variable expenses also play an important role and can be significant in some cases.
High Low Method Accounting FAQs
What does the Hi Lo method assume?
The high-low method presupposes constant fixed and unit variable expenses, which is not the case in real life. Variations in costs are not included in the estimate because it only employs two data values in its calculation.
Why is regression Better Than High low method?
Regression analysis is more accurate than the high-low method because the regression equation estimates cost using information from ALL data, whereas the high-low method uses only TWO observations. assesses the connection between the dependent variable and TWO OR MORE independent variables
What are the advantages of the scatterplot method over the high-low method?
The scatter graph method, which is more accurate than the high-low method, is used to separate blended costs. The scatter-graph method visibly separates expenses. The fixed and variable cost components can be identified from specific locations on the graph by charting the necessary data.
