To effectively plan, budget, and decide, a company needs to know how its costs behave. But it is not rare that companies do not have complete data or sophisticated analytical tools to understand their cost patterns. In such cases, the high-low method in accounting turns out to be a handy and simple-to-use tool. It enables management and accounting staff to separate a mixed cost into its fixed and variable components using only two points: the highest and lowest activity levels during a specific period.
What Is the High-Low Method?
The high-low method is a cost estimation instrument in managerial and cost accounting, which is used to identify the fixed and variable parts of mixed costs. A mixed cost has a component that is constant and does not change with the activity, and a variable component that increases as the activity increases. The high-low method, instead of determining the cost for all the transactions or activity levels, selects only the periods with the highest and lowest levels of activity and their corresponding total costs.
How the High-Low Method Works
1 Identify the Highest and Lowest Activity Levels
The initial step is identifying the periods featuring the most and least levels of activity within the timespan in question. These should be determined from activity units—such as labor hours, machine hours, or units produced—rather than from cost amounts. In addition, the total costs for these periods are also obtained.
2.Estimate Variable Cost Per Unit
The method basically assumes that the entire difference in total costs between the highest and lowest activity levels is the variable portion. Accountants calculate variable cost per unit by dividing the change in cost by the change in activity. It unveils how much the cost goes up each time the activity increases by one unit.
3.Estimate Total Fixed Cost
The known variable cost per unit is used to multiply the activity units of either the highest or the lowest period. They then take this estimated variable cost out of the total cost of that period. The leftover amount indicates the total fixed cost, which is considered to be constant over the relevant range of production.
4.Develop the Cost Equation
After the fixed and variable components are estimated, they are combined into a cost formula:
Total Cost=Fixed Cost+(Variable Cost Per Unit × Activity Units)
The managers will be able to use this formula to estimate expenses under any condition of operations within the same relevant range.
High Low Method Example
Here’s an example that will help you to understand the method.
Table below shows the total cost of production for a particular company in its first six-month period.
| Units | Total Cost |
| 3000 | $59,000 |
| 2720 | $55,000 |
| 2500 | $52,500 |
| 2150 | $50,500 |
| 1950 | $47,500 |
| 1250 | $38,000 |
To figure out the variable and fixed costs, use the formula above to figure out the variable cost per unit. Here, x2 equals 3000 and y2 equals $59,000, while x1 equals 1250 and y1 equals $38,000.
Using the calculation ($59,000 $38,000) (3,000 1,250), we arrive at a variable cost of $12 per unit.
Let’s figure out the fixed cost. Adding the value to the equation:
The fixed price will be $59,000 ($12,300) or $38,000 ($12,250). As a result, the total fixed cost is $23,000.
We can construct the cost volume function now that we have both fixed and variable costs. y = $23,000 + 12x will be the answer.
Advantages of the High-Low Method:
Simple and Easy to Apply.
The major advantage of the high-low method is its simple nature.There is no need for any special software, statistical skills, or complicated analysis. Anyone with a basic understanding of cost accounting can do it in no time, which makes it a tool accessible to managers and small businesses.
Useful When Data Is Limited
Some businesses, particularly small ones, may not provide detailed cost records. The high-low method is still very effective when only a minimum amount of data is available, thus being the perfect method for cases where the historical data is incomplete or has just been kept informally.
Time Saver
When compared with methods that require the analysis of numerous data points, the high-low method is limited only to the two most extreme levels of activity. In this way, the time needed for cost analysis is greatly shortened, which is very useful in situations where decisions have to be made quickly
Provides a Quick Estimate for Planning
While the outcomes are only rough, the approach still aids managers to:
- Predict how costs will change with activity levels
- Estimate budgets
- Evaluate pricing strategies
- Anticipate production costs
It provides a basic understanding of cost behavior, which can later be elaborated on by more sophisticated methods.
Supports Preliminary Decision-Making
Companies can utilize the high-low method to decide if they need to investigate further, simply by a glance at the data. It is the point where one can start forecasting and financial planning.
Disadvantages of the High-Low Method
Relies on Extreme Data Points
The biggest drawback of the method is its reliance on the highest and lowest activity levels only. These times may not reflect standard operations and may be affected by abnormal situations. Thus, it can generate cost estimates that are far from the typical cost behavior.
Ignores All Other Data
The high-low method simply looks at the highest and the lowest extremes of a company’s activity and cost records, even if the company has detailed records of its activities and costs. By doing this, it does not take into account any of the other points that could provide a more accurate picture. This method is less reliable when cost behavior is not stable.
Assumes Linear Cost Behavior
This method operates under the assumption that costs change in direct proportion to the activity. Nevertheless, costs may change because of:
- Economies of scale
- Step costs
- Changing efficiencies
- Changing market prices
Not Suitable for Long-Term Forecasting
The major factor why it is regarded as a short-term instrument for analysis is that the method fails to consider aspects such as inflation, changes in capacity, or cost variations over time.
Final Thoughts
The high-low method in accounting is an excellent method to determine fixed and variable costs approximately for a brief period of time, particularly when detailed data is not at hand.
Its simple nature makes it a tool that is readily available, efficient, and practical for budgeting and making decisions at an early stage. Nevertheless, since it depends on only two points and assumes that costs behave in a linear fashion, the method should be used sparingly. Essentially, the technique is a subsequent one for which a comprehensive cost analysis cannot be done. To get more accurate outcomes, enterprises should use it in combination with detailed methods like regression analysis or activity-based costing
