In cost accounting, the High-Low Method is a widely used technique to separate mixed costs into their fixed and variable components. It’s a simple method that helps businesses predict future costs based on historical data, making it especially useful for managers and accountants. But while it’s straightforward, it has its limitations, which we’ll also address in this guide.
What is the High-Low Method in Accounting?
The High-Low Method involves analyzing the highest and lowest levels of activity in terms of units produced or services provided, and the associated costs for those levels. By comparing these two extreme data points, accountants can estimate the variable cost per unit and the fixed cost, which can then be used to predict future costs.
This method is especially useful when a business is looking to analyze historical cost data and wants to estimate the future cost based on past performance. However, because it only uses the highest and lowest activity points, it may not always give a perfect representation of cost behavior, especially if there are significant variations or outliers.
High-Low Method Formula
The High-Low Method relies on three key formulas:
- Variable Cost per Unit Formula: This formula calculates the variable cost per unit produced.The variable cost per unit is calculated by taking the difference between the highest and lowest total costs, and then dividing it by the difference in the number of units produced at those activity levels
Variable Cost per Unit = (Highest Activity Units – Lowest Activity Units) / (Highest Activity Cost – Lowest Activity Cost)
- Total Fixed Cost Formula: Once you have the variable cost per unit, the next step is to calculate the fixed cost. This can be done using either the highest or lowest activity point. Here’s the formula for the fixed cost using the highest activity level:
Total Fixed Cost = Highest Activity Cost – (Variable Cost per Unit × Highest Activity Units)
- Total Cost Formula: After calculating the fixed and variable costs, the total cost can be calculated for any given level of activity (e.g., units produced or services provided):
- Total Cost = Total Fixed Cost + (Variable Cost per Unit × Units Produced)
Example: Applying the High-Low Method
Let’s walk through a fresh example to understand how to apply the High-Low Method.
Example Scenario: A Coffee Shop
Imagine a coffee shop that tracks its costs and the number of cups of coffee sold each month. Here’s the data they collected for the past six months:
| Month | Total Cost | Cups Sold |
|---|---|---|
| January | $6,000 | 1,200 |
| February | $5,000 | 1,000 |
| March | $7,000 | 1,500 |
| April | $5,500 | 1,100 |
| May | $6,500 | 1,300 |
| June | $8,000 | 1,600 |
Step 1: Identify the Highest and Lowest Activity Levels
- Highest Activity: June (1,600 cups, $8,000)
- Lowest Activity: February (1,000 cups, $5,000)
Step 2: Calculate the Variable Cost per Unit
Using the highest and lowest data points:
Variable Cost per Unit = (8,000 – 5,000) / (1,600 – 1,000) = 3,000 / 600 = 5 per cup
So, the variable cost to make each cup of coffee is $5.
Step 3: Calculate the Fixed Cost
Now, calculate the fixed cost using either the highest or lowest activity level. Let’s use the highest level (June):
Total Fixed Cost = 8,000 – (5 × 1,600) = 8,000 – 8,000 = 0
In this case, the coffee shop’s fixed costs are $0. This could happen in businesses where all costs are variable, or it may reflect a situation where rent or other fixed costs are covered by other means.
Step 4: Predict the Total Cost for July (1,400 Cups)
Using the fixed cost ($0) and the variable cost per unit ($5), we can predict the total cost for July, where 1,400 cups of coffee are expected to be sold:
Total Cost = 0 + (5 × 1,400) = 7,000
Therefore, the predicted total cost for July will be $7,000.
Advantages of the High-Low Method
- Simplicity: The method is quick and easy to apply with minimal data points, making it ideal for small businesses or quick cost analysis.
- Low Cost: You don’t need advanced tools or software to use this method, and it can be applied manually using basic cost data.
- Fast Estimation: It provides a fast way to estimate future costs based on historical data, which is valuable for budgeting and forecasting.
Disadvantages of the High-Low Method
- Accuracy: Because it only considers the highest and lowest points, the method may not account for fluctuations in costs that occur in other periods. It assumes that the relationship between activity and cost is linear, which is often not the case in real business scenarios.
- Outliers: Extreme values can distort the calculation, leading to less accurate predictions.
- Limited Use: The method may not be suitable for businesses with complex cost structures or those that require more granular analysis.
Conclusion
The High-Low Method is a practical and accessible tool for cost accountants to separate fixed and variable costs quickly. While it’s simple and effective for many scenarios, it’s important to be aware of its limitations, particularly when costs fluctuate or when more precise analysis is needed. By applying the high-low method formula, businesses can gain valuable insights into their cost structures and make better-informed decisions.