High-Low Method Definition, Formula, Calculate

Management accounting involves decision-making, planning, coordinating, controlling, communicating, and motivating. Similar to management accounting and financial accounting, there is cost accounting to determine the cost of a product. Although easy to understand, high low method may be unreliable because it ignores all the data except for the two extremes.

• Some common examples of these costs are supervision costs and marketing costs.
• It uses this comparison to estimate the fixed cost, variable cost, and a cost function for finding the total cost of different production units.
• It makes use of certain techniques to deduct an element of fixed cost from the total cost.
• Unfortunately, the only available data is the level of activity (number of guests) in a given month and the total costs incurred in each month.

Using either the high or low activity cost should yield approximately the same fixed cost value. Note that our fixed cost differs by $6.35 depending on whether we use the high or low activity cost. It is a nominal difference, and choosing either fixed cost for our cost model will suffice. The next step is to calculate the variable cost element using the following formula. However, suppose both levels of activities remain under the threshold of customarily fixed cost.

One has to consider step fixed cost/additional fixed cost to come up with the full fixed cost. Hence, the difference in total costs in both months is due to the difference in product level. Similar to management accounting, cost accounting is the process of allocating costs to cost items, which often comprise a business’s products, services, and other activities. Cost accounting is useful because it can show where a company spends money, how much it earns, and where it loses money. In any business, three types of costs exist Fixed Cost, Variable Cost, and Mixed Cost (a combination of fixed and variable costs). 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.

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In other words, it is the monetary value of expenditure for supplies, services, etc. For example, if the cost of a liter of milk is $2, the consumer has to spend $2 to acquire a liter of milk. Management accountants work for public companies, private companies, and government offices.

• Like any other theoretical method, the High-Low method of cost allocation also offers some limitations.
• Simply multiplying the variable cost per unit (Step 2) by the number of units expected to be produced in April gives us the total variable cost for that month.
• Due to its unreliability, high low method should be carefully used, usually in cases where the data is simple and not too scattered.
• Once variable cost per unit is found, you can calculate the fixed cost by subtracting the total variable cost at a specific activity level from the total cost at that activity level.
• 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.

This can effectively make it impossible to get a true average variable cost. Suppose a company Green Star provides the following production scenario for the 06 months of the production period. Cost accounting also helps in minimizing product costs as it highlights the reports of profit. Management accounting refers to identifying, analyzing, and communicating financial information to a firm’s managers to achieve the company’s future goals. Fixed costs are expenses that remain the same irrespective of the quantity or number of units of goods produced for sale or services rendered.

Calculate variable cost per unit using identified high and low activity levels

Once the variable cost per unit and the fixed costs are calculated, the future expected activity level costs can be determined using the same equation. The company wants to know the rate at which its electricity cost changes when the number of machine hours change. The part of the electric bill that does not change with the number of machine hours is known as the fixed cost. Fixed costs are monthly expenses that do not change depending on the level of production. Rent, depreciation, interest on loans, and lease charges are all examples. A cost that contains both fixed and variable costs is considered a mixed cost.

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The average activity level and the average cost for the periods in the database are then computed. The fixed cost is calculated by subtracting the variable cost for the average activity level from the total average cost. The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost ÷ change in number of units produced).

The Difference Between the High-Low Method and Regression Analysis

The analysis can also provide useful forecasts for future activity level cost analysis. However, the reliability of the variable costs with two extreme activity levels poses questions over the effectiveness of the method. In cost accounting, the high-low method is a way of attempting to separate out fixed and variable costs given a limited amount of data. The high-low method involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level. The biggest advantage of the High-Low method is that uses a simple mathematical equation to find out the variable cost per unit.

The Nature of a Mixed Cost

(Be sure to use the MHs that occurred between the meter reading dates appearing on the bill.) The cost of electricity was $16,000 in the month when its lowest activity was 100,000 MHs. This shows that the total monthly cost of electricity changed by $2,000 ($18,000 vs. $16,000) when the number of MHs changed by 20,000 (120,000 vs. 100,000). In other words, the variable cost rate was $0.10 per machine hour ($2,000/20,000 MHs). This is a very important concept in cost accounting and is very useful in determining fixed and variable costs related to the product, machinery, etc., and is also used in budgeting activities. It is a very simple method to analyze the cost without getting into complex calculations. High low method is the mathematical method that cost accountant uses to separate fixed and variable cost from mixed cost.

Step 3 of 3

We use the high low method when the cost cannot clearly separate due to its nature. Mixed cost is the combination of variable and fixed cost and it is also called “Semi Variable Cost”. Difference between highest and lowest activity units and their corresponding costs are used to calculate the variable cost per unit using the formula given above.

The fixed cost can then be calculated at the specific activity level i.e. either high level or low level of activity. Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable and fixed costs, we have total and fixed costs. 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.

In other words, as fixed cost is the same in both months, the fixed cost has been eliminated by deduction. Consider the total production cost of February was unadjusted trial balance example purpose preparation errors USD 45,000 and the number of units produced was 10,000. Similarly, the cost of production was USD, 55,000 and the number of units produced was 14,000.