Definition
High Low Method is a mathematical technique used to determine the fixed and variable elements of a historical cost that is partially fixed and partially variable.
Explanation
High Low Method provides an easy way to split fixed and variable components of combined costs using the following formula.
Variable Cost Per Unit:
= (Highest Activity Cost – Lowest Activity Cost)
÷
(Highest Activity Units – Lowest Activity Units)
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.
Fixed Cost:
= Highest Activity Cost – (Variable Cost Per Units x Highest Activity Units)
Or
Fixed Cost:
= Lowest Activity Cost – (Variable Cost Per Units x Lowest Activity Units)
Example
A company needs to know the expected amount of factory overheads cost it will incur in the following month.
Factory overheads cost in the previous three months was as follows:
Cost Units
Jan $30,000 6,000
Feb $20,000 5,000
Mar $25,000 4,000
Company expects to produce 7000 units in April.
Calculate the expected factory overhead cost in April using the High-Low method.
Solution
Step 1: Identify the highest and lowest activities
Highest activity level is 6000 units in Jan.
Lowest activity level is 4000 units in March.
It is important to remember here that it is the highest and lowest activity levels that need to be identified first rather than the highest/lowest cost.
Step 2: Calculate variable cost per unit
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.
Variable Cost Per Unit:
= (30,0000 – 25,000) ÷ (6000 – 4000)
= $2.5 Per Unit
Step 3: Calculate fixed cost
Fixed costs can be found be deducting the total variable cost for a given activity level (i.e. 6000 or 4000) from the total cost of that activity level.
Fixed cost = 30,000 – (2.5 x 6000) = $15,000
Step 4: Calculate total variable cost for new activity
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.
Total variable cost = $2.5 x 7000 = $17,500
Step 5: Calculate total cost
Simply adding the fixed cost (Step 3) and variable cost (Step 4) gives us the total cost of factory overheads in April.
Total cost = $15,000 + $17,500 = $32,500
Limitations
- High Low Method assumes a linear relationship between cost and activity which is an over simplified analysis of cost behavior. Activity based costing can provide a more useful analysis of the behavior of cost in relation to distinct activities.
- High Low Method is not representative of entire data as it is based on just 2 activity levels. Linear regression analysis overcomes the limitation of this method by incorporating data of all activity levels and is therefore more statistically reliable.
- High-low method does not account for the effect of inflation on a portion of financial data which could result in overestimation of the variable cost element of a mixed cost. The limitation can be overcome by adjusting the financial data for the effect of inflation before applying the high low method as explained in the example below.
Example 2: High-Low Method with Inflation
Sara is a management accountant in an organization. She has been assigned the task of budgeting payroll costs for the next quarter.
Payroll information of the last 4 quarters is as follows:
Quarter Work hours Cost $
1 15,000 400,0000
2 20,000 480,0000
3 18,000 440,0000
4 21,000 500,0000
The organization increments salaries and wages by 10% at the start of the 3rd quarter each year.
23,000 hours are expected to be worked in the first quarter of the next year.
Calculate the budgeted payroll costs for the next quarter.
Step 1: Identify the highest and lowest activities
Highest activity level is 21,000 hours in Q4.
Lowest activity level is 15,000 hours in Q1.
Step 2: Inflate the cost
Payroll cost of Q1 needs to be inflated by 10% so that we can calculate the actual difference in the cost arising from the change in work hours rather than passing on the effect of inflation in the prior period in future budgets.
Adjusted Payroll Cost of Q1: 400,000 x 1.10 = $440,000
Step 3: Calculate variable cost per unit
Variable Cost Per Unit:
= (500,000 – 440,000 [Step 2] ) ÷ (21,000 – 15,000)
= $10 per hour
Step 4: Calculate fixed cost
Fixed cost = 500,000 – (10 [Step 3] x 21000) = $290,000
Step 5: Calculate total variable cost for new activity
Total variable cost = 10 [Step 3] x 23,000 = $230,000
Step 6: Calculate total cost
Budgeted Payroll Cost = 290,000 [Step 4] + 230,000 [Step 5] = $520,000