High-Low Method Definition

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. 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.

Given the dataset below, develop a cost model and predict the costs that will be incurred in September. The main benefit of the high-low method is that it is simple to implement. Only when there is a relationship between the activity and that particular cost. What if, instead, the cost of snow removal for the runways is plotted against flight hours? In March, Waymaker produced 1,000 units and used 2,000 hours of production labor. Cost behavior describes how costs change as a result of changes in business activities.

1. 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.
2. Fixed costs are those expenses that remain unchanged regardless of the quantity of items you produce for sale.
3. Businesses can then use this to forecast when and how they might benefit from economies of scale.
4. 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.
5. The high-low method in accounting is the most preferred in the case when accountants need quick information related to the cost model.

You can then use these estimates in preparing your budgets or analyzing an expected monetary value for a contingency reserve. A scatter graph shows plots of points that represent actual costs incurred for various levels of activity. 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.

What is the high-low method?

They know what their costs were for June, but now they want to predict their costs for July. Fixed costs are those expenses that remain unchanged regardless of the quantity of items you produce for sale. For example, the rent you pay on the production facility will be the same whether you produce one cell phone case or one million cases. Based on that logic, you would rather get the most of your money by producing the highest number of cases and reducing the average fixed cost per unit.

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. The high-low method is actually a two-step process where the first step will help us to determine the estimated total cost per unit.

Similar to management accounting and financial accounting, there is cost accounting to determine the cost of a product. It is mainly useful to have a quick estimation of the cost model, or the cost structure, of a product. No, there are other methods apart from the high-low method accounting formula. Some https://www.wave-accounting.net/ popular methods are the scatter plot method, accounting, and regression analysis. The high-low method involves three main steps to calculate the cost for any level of production. High Low Method provides an easy way to split fixed and variable components of combined costs using the following formula.

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. J&L can make predictions for their costs because they have the data they need, but what happens when a business wants to estimate total costs but has not collected data regarding per-unit costs? This is the case for the managers at the Beach Inn, a small hotel on the coast of South Carolina.

High-Low Method

It only requires the high and low points of the data and can be worked through with a simple calculator. 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. 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.

Example of the high-low method

Once variable cost per unit is found, you can calculate the fixed cost by subtracting the total variable cost at a specific activity level from the total cost at that activity level. In scatter graphs, cost is considered the dependent variable because cost depends upon the level of activity. The activity is considered understanding the difference between revenue vs profit the independent variable since it is the cause of the variation in costs. Regent’s scatter graph shows a positive relationship between flight hours and maintenance costs because, as flight hours increase, maintenance costs also increase. This is referred to as a positive linear relationship or a linear cost behavior.

Hence, the manager needs to request from the CFO a total production budget of $87,750. To substitute the rest except a, we pick either the high or low point as reference. When you encounter an outlier, simply remove it from the dataset and use the high-low method for the remaining observations. 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.

Example of the High-Low Method

The second step of the process is where we take the cost per unit that we established from the first step and figure out the fixed costs for that level of production. Once we have those two pieces of information, we can use them to figure out the approximate cost for any level of production. In order to use the high-low method, you will have to combine the fixed and variable costs of production within your company to come up with a total cost. You will notice that the high-low method will only give you an estimate of what total costs would be at any given amount of production. These estimates are helpful to management when preparing budgets for upcoming months.

There’s no problem in using the high-low method in accounting since it still provides actionable information. Choosing between high-low or regression analysis methods is only a matter of capability and expertise. In the sample data above, the number of client calls refers to the activity level. The activity level can pertain to any measurable business activity, such as documents processed, units produced, finished goods inspected, or services rendered. It is presented in total, so we can’t immediately determine the fixed or variable components.

Their role is to collect, observe, and record numbers; advise on the company’s investments and manage them; budgeting, planning, risk management, and decision-making. For example, the table below depicts the activity for a cake bakery for each of the 12 months of a given year. Calculate the expected factory overhead cost in April using the High-Low method. Take your learning and productivity to the next level with our Premium Templates.

This method only requires two data points to provide estimates related to the cost structure. The high-low method in accounting is the most preferred in the case when accountants need quick information related to the cost model. This is not only because it is simple, but also because it does not require complex tools or programs. Variable costs are expenses that change depending on the quantity of production or number of units sold.