Written by The high-low method is a technique for estimating the fixed and variable components of a mixed cost by analyzing data from high and low activity levels.
It is a cost estimation technique that involves selecting the highest and lowest levels of activity within a given period and using the corresponding costs associated with those activity levels to estimate fixed and variable costs.
The high-low method assumes that costs can be divided into fixed and variable components, where fixed costs remain constant regardless of the activity level, while variable costs change in proportion to the activity level.
Steps in High-low Method
- Identify the highest and lowest levels of activity within a relevant range and their corresponding total costs.
- Use the formula \(\frac{\text{Highest cost – Lowest cost}}{\text{Highest Activity level -Lowest activity level}}\) to calculate the variable cost per unit.
- Once the variable cost per unit is calculated, multiply it by the activity level of either the highest or lowest point. Subtract this value from the corresponding total costs, and the result will represent the fixed costs.
- With the variable and fixed costs determined, you can create a cost equation in the form of Y = a + bX, where Y represents the total cost, a represents the fixed cost, b represents the variable cost per unit, and X represents the level of activity.
Example
XYZ company has the following data on its electricity costs and machine hours for the past six months:
| Month | Machine hours | Electricity cost ($) |
|---|---|---|
| January | 800 | 4,000 |
| February | 600 | 3,600 |
| March | 700 | 3,800 |
| April | 900 | 4,200 |
| May | 500 | 3,400 |
| June | 1000 | 4,400 |
In July, the factory expects to use 1200 machine hours. What is the variable cost per unit? Also, calculate the expected total electricity cost for July.
Solution:
The highest activity level is 1000 hours in June with a cost of $4,400, and the lowest activity level is 500 hours in May with a cost of $3,400.
Using the formula for variable cost per unit, we get:
Variable cost per unit = \(\frac{$4,400 – $3,400}{1000 – 500}\)= $2 per hour
Having gotten the variable cost per unit, the fixed cost can be calculated by using the activity level:
Y = a + bX
Using the activity level for June, Y= 4,400, b=2, x=1000,
4400=a + 2(1000)
4400-2000=a
a=2400
So, the fixed cost is 2400 and the total cost function will be:
Y=2400+2X
Let’s now calculate the total cost for the month of July where 1200 machine hours were used
Y=2400+2(1200)
Y=2400+2400=4800
So, the total cost in the month of July is $4800.
