It also aids in the control of project costs and the pre-determination of maintenance costs. We can examine long-term company trends and achieve the business goals with proper cost management. 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. No, there are other methods apart from the high-low method accounting formula. Some popular methods are the scatter plot method, accounting, and regression analysis.
In cost accounting, the high-low method is a technique used to split mixed costs into fixed and variable costs. Although the high-low method is easy to apply, it is seldom used because it can distort costs, due to its reliance on two extreme values from a given data set. The high-low method in accounting is used to separate the elements of variable and fixed costs from the total cost. It makes use of certain techniques to deduct an element of fixed cost from the total cost. The method makes use of two different levels of activities and related costs. High low method is the mathematical method that cost accountant uses to separate fixed and variable cost from mixed cost.
Step 02: Calculate the variable cost element
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. Whether it’s to figure out the profitability of a product, or getting an overview of the overall financial health of your business.
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- Fixed costs are expenses that remain the same irrespective of the quantity or number of units of goods produced for sale or services rendered.
- Let’s understand this procedural format of the concept with the following example.
- The manager of a hotel would like to develop a cost model to predict the future costs of running the hotel.
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The same variable cost per unit can also provide a forecast analysis. As the company can use it to predict the portion of fixed costs with fluctuating activity levels. The given formula provides the variable cost per unit of production. The high-low https://adprun.net/ method separates fixed and variable costs from the total cost by analyzing the costs at the highest and lowest levels of activity. It compares the highest level of activity and the lowest level of training and then compares costs at each level.
The high-low method can be done graphically by plotting and connecting the lowest point of activity and the highest point of activity. The y-intercept (value of y when x is zero) would be equal to the fixed cost. The high-low method can also be done mathematically for accurate computation. After a certain level of production, a firm requires more fixed investments, which cannot be covered by this method; therefore, this method should be used with extreme caution. The main disadvantage of the high-low method is that it oversimplifies the relationship between cost and production activity by only taking the highest and lowest data points into account. Variable costs are expenses that change depending on the quantity of production or number of units sold.
Step 01: Determine the highest and lowest level of activities and unit produced
Pick either the highest or lowest level of activity and fill in what we know. They differ in how they change as a result of changes in various business activities such as increased or decreased production, plans of expansion, budgeting for the firm, investing, etc. The company approves a 5% pay raise at https://online-accounting.net/ the start of each year and expects that work hours will be 20,000 for the next quarter considering the new hires. The accountant at an events management company is preparing a payroll budget based on costs from the past year. This can be used to calculate the total cost of various units for the bakery.
Example of the High-Low Method of Accounting
The high-low method is relatively unreliable because it only takes two extreme activity levels into consideration. High Low method will give us the estimation of fixed cost and variable cost, the result may be changed when the total unit and cost of both point change. https://www.wave-accounting.net/ We can calculate the variable cost and fixed cost components by using the High-Low method. Such a cost function may be used in budgeting to estimate the total cost at any given level of activity, assuming that past performance can reasonably be projected into future.
However, in many cases, the increased production levels need additional fixed costs such as the additional purchase of machinery or other assets. The higher production volumes also reduce the variable proportion of costs too. The high-low method can be used to identify these patterns and can split the portions of variable and fixed costs. It is a very simple method to analyze the cost without getting into complex calculations. Continuing with this example, if the total electricity cost was $18,000 when there were 120,000 MHs, the variable portion is assumed to have been $12,000 (120,000 MHs times $0.10). Since the total electricity cost was $18,000 and the variable cost was calculated to be $12,000, the fixed cost of electricity for the month must have been the $6,000.
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She has been assigned the task of budgeting payroll costs for the next quarter. One of the activities is expected to be higher with higher cost, and another is expected to be lower with lower cost. Due to its unreliability, high low method should be carefully used, usually in cases where the data is simple and not too scattered. For complex scenarios, alternate methods should be considered such as scatter-graph method and least-squares regression method. There are a number of accounting techniques used throughout the business world.