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.
When to Use the High-Low Method
Here are several situations in which it can be useful to use the high-low method:
Estimating utility costs for a manufacturing plan. A factory experiences fluctuating electricity costs due to varying production levels each month. By applying the high-low method, the company can separate the fixed portion (such as basic facility charges) from the variable portion (which increases with machine usage). This helps management predict future utility expenses and plan budgets accordingly.
Analyzing delivery and shipping cost. A logistics company incurs costs that include both fixed expenses (such as vehicle leases) and variable costs (like fuel and driver wages). By using the high-low method, the company can estimate how much of its total cost is dependent on the number of deliveries made. This helps optimize pricing strategies and determine cost-efficient delivery schedules.
Determining maintenance costs for equipment. A construction company notices that monthly maintenance costs fluctuate based on how frequently equipment is used. By applying the high-low method, the company can separate fixed costs (such as routine inspections) from variable costs (such as repairs due to heavy usage). This analysis allows the company to plan maintenance budgets and allocate costs effectively.
Forecasting customer service expenses. A call center experiences varying labor and utility costs depending on the number of customer calls handled. The high-low method can help distinguish fixed costs (such as rent and basic staffing) from variable costs (such as overtime pay for peak call periods). This insight helps management adjust staffing levels and control costs efficiently.
Evaluating sales commissions and administrative costs. A retail chain pays sales staff a base salary (fixed cost) plus commissions (variable cost) based on sales volume. Using the high-low method, the company can estimate how much its payroll expenses will fluctuate with different sales levels. This helps in setting sales targets and budgeting for compensation expenses.
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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.