By only requiring two data values and some algebra, cost accountants can quickly and easily determine information about cost behavior. Also, the high-low method does not use or require any complex tools or programs. The manager of a hotel would like to develop a cost model to predict the future costs of running the hotel.

The high low method is an accounting technique used to estimate the fixed and variable cost of production in businesses. This approach is valuable in cost accounting as it examines and compares the total costs at the highest and lowest levels of activity. This article will explore how to calculate the variable cost and other aspects of the high-low cost model.

Comparing the High-Low Method with Other Cost Estimation Techniques

• While the method provides a quick estimate, it should be used cautiously due to its sensitivity to outliers and limited data usage.
• The high-low method is generally not so popular because it can lead to a wrong interpretation of the data if there are changes in variable or fixed cost rates over time.
• CFI is on a mission to enable anyone to be a great financial analyst and have a great career path.

Manufacturers can estimate production costs, retailers can track warehouse expenses, and service-based businesses can determine operational costs based on customer demand. Since the method applies to any business that experiences fluctuations in activity, it can be a valuable tool in financial decision-making. By following these steps, you’ll get a rough idea of how much of your total cost is fixed and how much changes with business activity. It assumes a linear relationship—meaning that costs increase at a constant rate as business activity rises. While this isn’t always true in the real world, it provides a good rough estimate.

Why Businesses Use It

For long-term financial planning, more comprehensive methods that consider a broader range of data and variables are recommended to ensure precision and reliability. For businesses that need a rough estimate, the high-low method is a helpful tool. However, for those requiring greater accuracy, more advanced techniques like regression analysis or scatter plot methods should be considered.

How to determine the fixed cost

High Low Method provides an easy way to split fixed and variable components of combined costs using the following formula. Using either the high cloud bookkeeping or low activity cost should yield approximately the same fixed cost value. Note that our fixed cost differs by $6.35 depending on whether we use the high or low activity cost. It is a nominal difference, and choosing either fixed cost for our cost model will suffice. Given the variable cost per number of guests, we can now determine our fixed costs.

For businesses with highly variable expenses, relying on the high-low method alone can lead to incorrect cost estimates. Companies with more detailed financial data should consider using alternative methods that provide a more precise picture of cost behavior. While this method provides a quick estimate, it doesn’t account for fluctuations in gas prices or maintenance costs.

• The high-low method can also be done mathematically for accurate computation.
• Sometimes it is necessary to determine the fixed and variable components of a mixed cost figure.
• It is possible for the analysts and accountants to use this method effectively for determining both the fixed and variable cost component.

The Step-by-Step Process

Mixed cost is the combination of variable and fixed cost and it is also called “Semi Variable Cost”. The high-low point method uses only two data points (i.e., the highest and the lowest activity levels) which are generally not enough to get the satisfactory results. Moreover, these highest and lowest points often do not represent the usual activity levels of a business entity. direct vs indirect costs The high-low point formula may, therefore, misrepresent the firm’s true cost behavior when it operates at normal activity level.

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 should be excluded before using high-low method. Due to the simplicity of using the high-low method to gain insight into the cost-activity relationship, it does not consider small details such as variation in costs. The high-low method assumes that fixed and unit variable costs are constant, which is not the case in real life.

This fixed cost remains consistent regardless of the number of units produced. In this example the highest activity is 2,700 units and the lowest activity is 500 units. Businesses that require quick estimates can use the high-low method, while those needing higher accuracy should explore more data-driven approaches.

Total Fixed Cost

It uses only the lowest and highest production activities to estimate the variable and fixed cost, by assuming the production quantity and cost increase in linear. It ignores the other points of productions, so it may be an error when the cost does not increase in a linear graph. 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.

It is essential to note that the High-Low method is not very popular as it relies on extreme values of the population and can distort the cost distribution. However, the technique is one of the fastest to outline an estimation when developing forecast models and trying out different approaches to the initial assumptions for the model. While the high-low method is useful, it should be seen as a starting point rather than a final answer. Businesses should compare its results with other cost estimation methods before making important financial decisions. While the high-low method is useful for quick estimates, it’s not the most accurate approach.

The high-low method used in analysis of costs that help in estimating the variable and fixed costs from a given data set of financial information. Using this formula, it is possible to estimate the costs individually but may not always provide actual estimate due to certain limitations. As compared to scatter graph and least squares regression method, working with high-low point method is simple and easy. However, this method has some serious limitations which the managers must be fully aware of before using it to separate variable and fixed portions of a mixed cost. If the highest or lowest activity level was caused by an unusual event, such as a temporary supply shortage nonprofit survey examples or a one-time bulk order, the calculation might be inaccurate.

The company hasfound that if a delivery truck is driven for 52,500 miles in a month, its average operating cost comes to45.6 cents per mile. If the same truck is driven for only 35,000 miles in a month, its averageoperating cost increases to 53.6 cents per mile. The Western Company presents the production and cost data for the first six months of the 2015. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. Industries where costs follow a predictable pattern—such as logistics, retail, and manufacturing—can benefit from the high-low method.