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CandleFocus Glossary Editor
The High-Low Method is a simple approach used to analyze and segregate costs. It relies on two critical points of data when determining cost behavior for a period of time – the highest level of activity achieved in the period and the lowest level of activity achieved in the period. By figuring out the cost for the highest and lowest levels of activity, and then dividing it by the difference in activity levels of the two points, it is possible to calculate the cost behavior component’s variable and fixed cost components.
For example, a business owner can analyze monthly costs of $10,000 in total with a highest activity level of 250 units and a lowest activity level of 150 units. To calculate the variable cost component of this activity, the owner must divide the difference in cost between the high and low periods by the difference in activity between these periods (i.e., $5,000 difference in costs / 100 units difference). This calculation yields a variable rate of cost of $50 per unit (($5,000/100 units)). Taking the total cost of $10,000 and subtracting the variable rate of cost of $50 per unit will result in the fixed cost component of $7,500 (i.e., 10,000 - 5,000 = $7,500).
Though the high-low method is simple, it relies on the assumption that the variable and fixed costs remain constant through the period - which does not reflect reality. A more accurate cost-estimating method includes least-squares regression, for which more complex calculations need to be used. This method applies linear regression analysis to the data points, specifically examining the association between the cost and the production or activity quantity.
In conclusion, the high-low method is a simple way to segregate costs with minimal information. However, this simplicity assumes the variable and fixed costs remain constant which is not realistic. Various cost-estimating methods can be used to provide more accurate results; the least-squares regression method is especially useful as it examines the association between the cost and the production or activity quantity.
For example, a business owner can analyze monthly costs of $10,000 in total with a highest activity level of 250 units and a lowest activity level of 150 units. To calculate the variable cost component of this activity, the owner must divide the difference in cost between the high and low periods by the difference in activity between these periods (i.e., $5,000 difference in costs / 100 units difference). This calculation yields a variable rate of cost of $50 per unit (($5,000/100 units)). Taking the total cost of $10,000 and subtracting the variable rate of cost of $50 per unit will result in the fixed cost component of $7,500 (i.e., 10,000 - 5,000 = $7,500).
Though the high-low method is simple, it relies on the assumption that the variable and fixed costs remain constant through the period - which does not reflect reality. A more accurate cost-estimating method includes least-squares regression, for which more complex calculations need to be used. This method applies linear regression analysis to the data points, specifically examining the association between the cost and the production or activity quantity.
In conclusion, the high-low method is a simple way to segregate costs with minimal information. However, this simplicity assumes the variable and fixed costs remain constant which is not realistic. Various cost-estimating methods can be used to provide more accurate results; the least-squares regression method is especially useful as it examines the association between the cost and the production or activity quantity.