High-low method definition
/What is the High-Low Method?
The high-low method is an accounting technique used to discern the fixed and variable portions of a mixed cost. The essential concept is to collect the cost at a high activity level and again at a low activity level, and then extract the fixed cost and variable cost components from this information. The concept is useful in the analysis of pricing and the derivation of budgets. It could be used to determine the fixed and variable components of the costs associated with a product, product line, machine, store, geographic sales region, subsidiary, or customer.
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The Nature of a Mixed Cost
A cost that contains both fixed and variable costs is considered a mixed cost. An example of a mixed cost is a production line, where fixed costs include the wages of the employees required to man all work stations along the line, and variable costs include the materials used to construct the products passing through the production line. The cost of any aggregated activity is likely to be a mixed cost.
Example of the High-Low Method of Accounting
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.
Problems with the High-Low Method
The high-low method is subject to several problems that tend to yield inaccurate results. The problems are as follows:
Outlier data. Either the high or low point information (or both!) used for the calculation might 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. You can reduce this potential problem by collecting information at other activity levels and affirming the fixed and variable relationships at these other levels. The result could be that the furthest data points are thrown out, resulting in a more reliable high-low analysis.
Step costs. Some costs are only incurred at specific volume points and not below those volumes. If a step cost occurred at a volume level between the high and low points used for the calculation, costs would rise because of the step cost, and be incorrectly considered variable costs when the step cost point could have triggered an increase in either the variable or the fixed cost.
Estimate only. This technique does not yield precise results, because there are too many variables that can impact both the costs and unit volumes required for the calculation. For example, what if the unit volume is lower than usual because a batch of product is scrapped? Or what if the cost is higher because a machine was broken and the company had to incur overtime charges to complete the production on time?
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.