Understanding the High-Low Method in Cost Estimation

Both of these costs have an impact on overall profitability and knowing each will help you make better decisions. Differentiating fixed and variable components can also aid in breakeven point analysis wherein you can determine the minimum revenue you need to reach breakeven point or the point at profit is zero. By focusing only on the highest and lowest activity levels, the high low method ignores all other data points. This means that any patterns or trends in the intermediate data are completely disregarded, potentially missing valuable information about cost behavior. In accounting, the high low method is a cost estimation technique that determines the fixed and variable elements within a mixed cost. Mixed costs contain both fixed components (costs that remain constant regardless of production volume) and variable components (costs that change proportionally with production).

Understanding the High-Low Method for Cost Estimation in Business Finance

Once these points are determined, they serve as the basis for the entire cost estimation process.
Identifying the variable cost per unit and the fixed cost component helps businesses understand how costs change with activity levels.
It’s also possible to draw incorrect conclusions by assuming that just because two sets of data correlate with each other, one must cause changes in the other.
Using the High-Low Method, we can now determine the total cost of producing 350 units.
We can easily calculate the total cost since we have the variable and fixed costs per unit.
However, the high low method offers a quick and accessible alternative when regression analysis isn’t feasible or necessary.
Discover how the high-low method simplifies cost analysis in accounting by estimating variable and fixed costs for better financial decision-making.

It can be argued that activity-cost pairs (i.e. activity level and the corresponding total cost) which are not representative of the set of data should be excluded before using high-low method. Discover how the high-low method simplifies cost analysis in accounting by estimating variable and fixed costs for better financial decision-making. Cost estimation is a critical component of financial planning and analysis in business. It enables organizations to forecast expenses, prepare budgets, and make informed decisions. Among the various techniques available for cost estimation, the high-low method stands out for its simplicity and practical application.

The High Low Method: How to Split Variable and Fixed Costs

In the example above the variable cost per unit is 5.00 and fixed costs are 40,000. To calculate the variable cost using the High-Low Method, subtract the fixed cost component from the total cost at either the highest or lowest activity level. The High-Low Method is widely used in cost estimation because it offers a straightforward and practical way to analyze costs.

Inability to Handle Complex Cost Behaviors

This blog post looks deeper into the High-Low Method and uncovers its practical applications in cost estimation. For the months from June to August, the actual costs are always higher than the computed costs. These variances can stem from different causes, and every business manager should look at the variances.

The high-low method is a form of cost analysis that businesses use to predict future costs based on past expenses. It is a straightforward approach that requires minimal data to execute, making it an accessible option for many businesses. High-low point method is a technique used to divide a mixed cost into its variable and fixed components.

Step 03: Find the fixed cost element

Contact us at CFO Consultants LLC to discover how we can help you grow your business by optimizing your cost estimation processes. Remember, informed decision-making in business starts with accurate cost estimation. By substituting the amounts in the cost equation of the lowest point, we can determine the fixed cost (a). To learn more about bookkeeping, our guide on small business bookkeeping will teach you how to perform small business bookkeeping and how to organize accounting data appropriately.

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.
By using this method, we observe only the highest and lowest points in the data set with the assumption that all the data have a linear relationship.
The resulting regression line provides an equation that can be used to estimate costs at various levels of activity.
Mixed cost is the combination of variable and fixed cost and it is also called “Semi Variable Cost”.
The high-low method may produce inaccurate results since it only considers two extreme data points, which may not be representative of other data points.
To learn more about bookkeeping, our guide on small business bookkeeping will teach you how to perform small business bookkeeping and how to organize accounting data appropriately.
A company needs to know the expected amount of factory overheads cost it will incur in the following month.

It considers the total dollars of the mixed costs at the highest volume of activity and the total dollars of the mixed costs at the lowest volume of activity. The total amount of fixed costs is assumed to be the same at both points of activity. The change in the total costs is thus the variable cost rate times the change in the number of units of activity. Least squares regression is a statistical method used to determine the line of best fit through a set of data points on a scatter plot.

High Low Method in Accounting

A company needs to know the expected amount of factory overheads cost it will incur in the following month. Eric Gerard Ruiz, a licensed CPA in the Philippines, specializes in financial accounting and reporting (IFRS), managerial accounting, and cost accounting. what are investing activities He has tested and review accounting software like QuickBooks and Xero, along with other small business tools. Eric also creates free accounting resources, including manuals, spreadsheet trackers, and templates, to support small business owners. Each method has its own strengths and appropriate applications, with regression analysis generally considered the gold standard for statistical validity.

The Cost Function

By using the formula in computing the variable cost per unit, let’s substitute the figures we gathered from Step 1. The company plans to produce 7,000 units in March 2019 on the back of buoyant market demand. Help the company accountant calculate the expected factory overhead cost in March 2019 using the high-low method. Let us try to understand the concept of high-low method total cost formula with the help of some suitable examples.

The straightforward approach makes it easy to explain to non-financial stakeholders how costs were estimated. Unlike regression analysis, the high low method provides no statistical measures to assess the reliability of the results. There are no confidence intervals, correlation coefficients, or other statistics to validate the findings. Due to its unreliability, high low method should be carefully used, usually in cases where the data is simple and not too scattered. For complex scenarios, alternate methods should be considered such as scatter-graph method and least-squares regression method.

It helps make informed decisions about cost control, pricing strategies, and resource allocation. In the context of cost analysis, it is crucial to distinguish between fixed and cost per equivalent unit calculator variable costs. Fixed costs are expenses that remain unchanged over a specific range of activities. They do not fluctuate based on the number of units produced or the volume of services provided.

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for why compliance is the most important part of business today all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.