In all three examples, managers used cost data they have collected to forecast future costs at various activity levels. The high-low method is an accounting technique that is used to separate out your fixed and variable costs within a limited set of data. 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. Because it uses only two data values in its calculation, variations in costs are not captured in the estimate.
Demonstration of the High-Low Method to Calculate Future Costs at Varying Activity Levels
- The highest activity for the bakery occurred in October, when it baked the highest number of cakes, while August had the lowest activity level, with only 70 cakes baked at a cost of $3,750.
- If the scatter graph reveals a linear cost behavior, then managers can proceed with a more sophisticated analyses to separate mixed costs into their fixed and variable components.
- There was an incremental change between the two periods of $15,000 and 5,000 units, so the variable cost per unit during July must be $15,000 divided by 5,000 units, or $3 per unit.
- When creating the scatter graph, each point will represent a pair of activity and cost values.
In this case, it would be February and May, as shown in Figure 2.33. We always choose the highest and lowest activity and bottom up forecasting the costs that correspond with those levels of activity, even if they are not the highest and lowest costs. When creating the scatter graph, each point will represent a pair of activity and cost values. Maintenance costs are plotted on the vertical axis (Y), while flight hours are plotted on the horizontal axis (X). For instance, one point will represent 21,000 hours and $84,000 in costs.
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. This technique provides a simple and straightforward way to split fixed and variable components of combined costs. We’ll take a closer look at how you can utilise this technique and learn how to estimate your fixed and variable costs. The high or low points used for the calculation may not represent the costs normally incurred at those volume levels due to outlier costs that are higher or lower than would normally be incurred.
Steps in Performing the High-Low Method
ABC International produces 10,000 green widgets in June at a cost of $50,000, and 5,000 green widgets in July at a cost of $35,000. There was an incremental change between the two periods of $15,000 and 5,000 units, so the variable cost per unit during July must be $15,000 divided by 5,000 units, or $3 per unit. Since we have established that $15,000 of the costs incurred in July were variable, this means that the remaining $20,000 of costs were fixed. The high-low method is an easy way to accounting for asset exchanges segregate fixed and variable costs.
Because of the preceding issues, the high-low method does not yield overly precise results. Thus, you should first attempt to discern the fixed and variable components of a cost from more reliable source documents, such as supplier invoices, before resorting to the high-low method. By substituting the amounts in the cost equation of the lowest point, we can determine the fixed cost (a). Calculating the outcome for the high-low method requires a few formula steps. First, you must calculate the variable-cost component and then the fixed-cost component, and then plug the results into the cost model formula.
The high-low method is relatively unreliable because it only takes two extreme activity levels into consideration. The high or low points used for the calculation may not be representative of the costs normally incurred at those volume levels due to outlier costs that are higher or lower than would normally be incurred. The highest activity for the bakery occurred in October, when it baked the highest number of cakes, while August had the lowest activity level, with only 70 cakes baked at a cost of $3,750. The cost amounts adjacent to these activity levels will be used in the high-low method, even though these cost amounts are not necessarily the highest and lowest costs for the year. As you can see from the scatter graph, there is really not a linear relationship between how many flight hours are flown and the costs of snow removal.
High-Low Method: Learn How to Estimate Fixed & Variable Costs
Estimation is also useful for using current data to predict the effects of future changes in production on total costs. Three estimation techniques that can be used include the scatter graph, the high-low method, and regression analysis. Here we will demonstrate the scatter graph and the high-low methods (you will learn the regression analysis technique in advanced managerial accounting courses. 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. Because the trend line is somewhat subjective, the scatter graph is often used as a preliminary tool to explore the possibility that the relationship between cost and activity is generally a linear relationship.
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Using the maintenance cost data from Regent Airlines shown in Figure 2.32, we will examine how this method works in practice. Let’s say that you are running a business producing high end technology products. You need to know what the expected amount of overheads that your production line will incur in the next month.