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The high-low method is used in cost accounting to estimate fixed and variable costs based on a company’s highest and lowest activity levels. By focusing on these extremes, the high-low method helps determine the variable costs per unit and the total fixed costs. This provides insight into how costs fluctuate with production. The high-low method is useful for both companies and investors looking for a quick estimate of cost behavior without delving into more detailed financial data.
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The high-low method is a cost estimation method that identifies the variable and fixed costs within a company by using only the highest and lowest activity points. Activity levels can be based on the number of products produced, the number of employees employed, or a similar measure. This method calculates the variable costs per unit based on these extremes and then applies them to determine the total fixed costs.
By analyzing high and low data points, the high-low method creates a cost model that can help predict costs at different levels of production. However, a linear relationship between activity levels and costs is assumed. This makes it most reliable in stable environments with minimal cost fluctuations.
To calculate costs using the high-low method, here are the steps:
The formula for variable costs per unit is:
Variable costs = (highest activity costs – lowest activity costs) ÷ (highest activity units – lowest activity units)
Here, the highest and lowest activity units refer to the periods of maximum and minimum activity levels, respectively. Use the number of products shipped, the number of customers served, or a similar metric instead of costs to identify the highest levels of activity. This period can be a month, a quarter or another time period.
Once the variable costs have been calculated, use this value to find the fixed costs with the following formulas:
Fixed costs = highest activity costs – (variable costs × highest activity units)
Fixed costs = lowest activity costs – (variable costs × lowest activity units)
Finally, use the calculated variable and fixed costs to determine the total costs at a specific activity level:
Total costs = fixed costs + (variable costs x activity units)
As an example of using the high-low method, let’s assume that a company that tracks the quantity and cost of products it makes each month wants to understand cost variances during the fiscal year. Here is a monthly overview:
For this example, the highest activity occurs in October, with 1,500 units produced, costing this hypothetical company $58,000. The lowest activity is in May, with 900 units produced, costing $39,000.
Using the high-low variable cost formula:
Variable costs = ($58,000 – $39,000) ÷ (1,500 – 900)
Variable costs = $19,000 ÷ 600
Variable costs = $31.67 per unit
Choose the highest or lowest point to solve for the fixed costs. Let’s assume the company wants to start with the high point:
Fixed costs = $58,000 – ($31.67 × 1,500)
Fixed costs = €58,000 – €47,505
Fixed costs = $10,495
Now let’s turn it around and assume the company wants to use the low point:
Fixed costs = $39,000 – ($31.67 × 900)
Fixed costs = $39,000 – $28,503
Fixed costs = $10,497
The fixed costs are virtually identical for both the high and low points. This indicates that the high-low method was performed correctly. It shouldn’t matter whether you use the high or low points, because the relative difference between each metric is similar on its own.
Using the calculated fixed and variable costs for the peak and an estimated production of 2,000 units, the total cost equation becomes:
Total cost = $10,495 + ($31.67 × 2,000)
Total cost = $10,495 + $63,340
Total cost = $73,835
A similar calculation can suggest likely costs for other levels of production. Once the variable cost figure is known, all you need to do is multiply it by the expected production figure and add the fixed costs.
The high-low method helps companies quickly estimate costs and can allow them to predict future expenses for different levels of production. This method is especially useful for companies with seasonal production fluctuations because it helps establish cost baselines and identify how fixed and variable costs affect total expenses.
Although practical, the high-low method has some limitations. It relies only on the highest and lowest extremes and overlooks other levels of activity. This can lead to inaccuracies if these extremes are not typical of regular business operations.
In addition, the high-low method assumes a linear relationship between costs and activity, which may not apply in all business scenarios. For businesses with fluctuating or irregular costs, alternative cost estimating methods can provide a more accurate view of costs.
The high-low method is especially beneficial for small business owners, financial analysts and accountants who need a quick and easy way to estimate fixed and variable costs. This is especially useful when detailed cost data is limited, allowing quick approximations of cost behavior to inform budgeting and decision-making processes.
In personal or business budgeting, the high-low method can separate fixed costs, such as base fees, from variable costs, such as usage-based expenses. For example, individuals can analyze utility bills to see what portion remains constant and what portion changes with consumption. Small businesses can use it to understand and plan supply or production costs more effectively.
This method can also support decision-making by revealing how costs might change in different scenarios. For investors, it provides insight into a company’s cost structure, allowing them to assess its efficiency and growth potential. By applying the high-low method, readers can better understand cost behavior and use it to plan or evaluate opportunities.
The main advantage of the high-low method is its simplicity. Only the highest and lowest activity levels and associated costs are needed to estimate the variable and fixed cost components.
Regression analysis takes into account all available data points to provide a more accurate estimate of cost behavior, capturing variations and trends that the high-low method might miss. However, regression analysis is more complex and requires statistical software or advanced calculations, while the high-low method offers a faster alternative, albeit at the expense of some degree of accuracy.
The high-low method is a useful tool for estimating fixed and variable costs, allowing companies to predict how expenses will change with activity levels. While not without limitations, it provides a quick and accessible way to analyze cost behavior. For investors and entrepreneurs, the high-low method can support better cost control, financial planning and investment decisions.
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The post How the High-Low Method Works and How to Calculate It first appeared on SmartReads from SmartAsset.
