High-Low Method in Cost Accounting: Definition and Application

A comprehensive guide to understanding the High-Low Method in cost accounting, including its definition, application, examples, and limitations.

The High-Low Method is a cost accounting technique used to estimate the fixed and variable components of a company’s total costs. Given a limited amount of data, this method utilizes the highest and lowest levels of activity and their associated costs to determine a linear cost function. It is particularly useful for businesses that need to make quick cost estimates without complex statistical tools.

How to Apply the High-Low Method

Steps to Perform the High-Low Method

• Identify the Highest and Lowest Activity Levels:

  • Select the periods with the highest and lowest levels of activity (output or production).

• Determine the Corresponding Costs:

  • Record the total costs associated with these highest and lowest levels of activity.

• Calculate the Variable Cost per Unit:

  • Use the formula:
    $$ \text{Variable Cost per Unit} = \frac{\text{Cost at Highest Activity Level} - \text{Cost at Lowest Activity Level}}{\text{Highest Activity Level} - \text{Lowest Activity Level}} $$

• Calculate the Total Fixed Cost:

  • Use the total cost equation at either the highest or lowest activity level to find the fixed cost:
    $$ \text{Fixed Cost} = \text{Total Cost} - (\text{Variable Cost per Unit} \times \text{Activity Level}) $$

• Formulate the Cost Equation:

  • Combine the fixed and variable costs into a cost equation:
    $$ \text{Total Cost} = \text{Fixed Cost} + (\text{Variable Cost per Unit} \times \text{Activity Level}) $$

Example of High-Low Method

Data

Let’s assume the following data for a manufacturing company:

• Highest Activity Level: 5,000 units, Total Cost: $50,000
• Lowest Activity Level: 1,000 units, Total Cost: $20,000

Calculation

• Variable Cost per Unit:

  $$ \frac{50,000 - 20,000}{5,000 - 1,000} = \frac{30,000}{4,000} = 7.50 \text{ per unit} $$

• Fixed Cost (using highest activity level):

  $$ \text{Fixed Cost} = 50,000 - (7.50 \times 5,000) = 50,000 - 37,500 = 12,500 $$

• Cost Equation:

  $$ \text{Total Cost} = 12,500 + (7.50 \times \text{Activity Level}) $$

Advantages and Disadvantages

Advantages

• Simplicity: Easy to apply with minimal data requirements.
• Quick Estimation: Useful for rapid cost analysis and decision-making.

Disadvantages

• Accuracy: Less accurate than methods using more comprehensive data.
• Assumption of Linearity: Assumes a linear relationship between cost and activity levels, which may not always hold true.
• Outlier Influence: Highest and lowest points might be outliers, affecting the accuracy of estimates.

Related Terms

• Fixed Costs: Costs that do not change with varying levels of production.
• Variable Costs: Costs that vary directly with the level of production.
• Mixed Costs: Costs containing both fixed and variable elements.

FAQs

Q: Can the High-Low Method be used for all types of costs?

A: No, the High-Low Method is best suited for costs that have a clear and predictable relationship with activity levels. It is not ideal for costs with irregular patterns.

Q: How does the High-Low Method compare to regression analysis?

A: Regression analysis uses all data points to estimate costs and is generally more accurate but more complex. The High-Low Method uses only two data points, making it simpler but less precise.

Summary

The High-Low Method is a valuable tool for cost accounting, enabling the separation of fixed and variable costs with minimal data. While it offers simplicity and speed, it is important to be mindful of its limitations, particularly regarding accuracy and the assumption of linearity.

References

• Garrison, Ray H., Eric W. Noreen, and Peter C. Brewer. “Managerial Accounting.” McGraw-Hill/Irwin, 2021.
• Horngren, Charles T., Srikant M. Datar, and Madhav V. Rajan. “Cost Accounting: A Managerial Emphasis.” Pearson, 2020.