The high-low method in accounting is used to separate the elements of variable and fixed costs from the total cost. It makes use of certain techniques to deduct an element of fixed cost from the total cost. The method makes use of two different levels of activities and related costs.
One of the activities is expected to be higher with higher cost, and another is expected to be lower with lower cost. That’s why the method is called the high low method.
How it works
The cost of lower activity is deducted from the cost of higher activity and the resultant is written in the numerator. Similarly, a low level of production is deducted from a higher level of production and placed in the denominator. In other words, a difference in the cost is divided by the difference in the level of production.
The given formula provides the variable cost per unit of production. The logic behind the concept is that when the total cost of lower activity is deducted from the total cost of higher activity, the fixed cost included in the total cost of a lower activity is deducted from the fixed cost of the higher level of activity along with variable cost (to the extent of equality in both production levels).
Hence, the numerator is left with the variable cost of the differential units, and when the variable cost of differential units is divided with differential units it results in variable cost per unit. Let’s understand this procedural format of the concept with the following example.
Consider the total production cost of February was USD 45,000 and the number of units produced was 10,000. Similarly, the cost of production was USD, 55,000 and the number of units produced was 14,000. There is no fluctuation of fixed costs in February and March.
Hence, the difference in total costs in both months is due to the difference in product level. We shall put the figures in the formula given above.
Both figures given in the numerator contain the same fixed cost. Hence, when we deduct USD 45,000 in USD 55,000, the fixed cost is net and the variable cost to the extent of equality in the level of production is eliminated. In other words, as fixed cost is the same in both months, the fixed cost has been eliminated by deduction.
Similarly, the variable cost of producing 10,000 units has been deducted from the total cost of USD 55,000 at the higher level of activity. Hence, the remaining balance of the numerator is the variable cost of differential 4,000 units.
The division of differential cost with the differential level of activity results in the variable cost per unit. So, the differential cost of USD 10,000 divided by differential units of 4,000 results in USD 2.5 per unit (10,000/4,000).
We have found per unit of variable cost and can use it to find variable cost at any level of production. We simply need to multiply per unit cost by the level of production. For instance, the level of production in February was 10,000 units. So, USD 25,000 (10,000*USD 2.5/per) is the variable cost for the month of February.
Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable and fixed costs, we have total and fixed costs.
So, if we deduct the variable cost from the total cost we get a fixed cost for the month. Like, USD 45,000 – USD 25,000 = USD, 20,000 which is fixed cost. Hence, the total cost is USD 45,000, of which the variable cost is USD 25,000 and the fixed cost is USD 20,000.
- Limited data is required to finalize the calculations in the high-low method.
- It’s easy to separate the variable and fixed costs with some basic procedural calculations.
- Only two levels of activities and respective costs are required irrespective of other details.
- An accountant can obtain all the required data from the internal books of the business and does not have to collect data from any external source. It really makes the process fast.
- The figures calculated with the high low method are estimates and not exact numbers. If exact information is required external vendor needs to be contacted or their documents can be analyzed.
- The high-low method ignores small details like variation in cost, economies of scale, and fluctuation in the cost of manufacturing. Further, it assumes there is no change in the fixed cost even in different periods.
- The results produced by the high low method can easily be obtained by analysis of accounting records like cost cared etc. which is more reliable. So, there seems to less importance on the high low method.
Step fixed cost
Sometimes, the change of activity level increases the fixed cost. For instance, the factory got a monthly production capacity of 10,000 units and paid USD 10,000 per month. However, the company needs to produce 15,000 units in some particular month.
So, to produce additional 5,000 units, the company has to extend their production facility, which is expected to incur the cost same as the previous facility of 10,000 units. Hence, once the limit of normal production capacity is reached, the company has to incur another fixed cost irrespective of additional units to be produced.
It is important to note that if a higher level of activity is above a threshold of normal production. One has to consider step fixed cost/additional fixed cost to come up with the full fixed cost.
However, suppose both levels of activities remain under the threshold of customarily fixed cost. In that case, there is no need to consider step fixed cost in calculating the high low method.