Understanding the High-Low Method Formula in Accounting

The high-low method is a valuable tool used in cost accounting to separate fixed and variable costs. This article will provide a comprehensive understanding of the high-low method formula and how it works.

What is the High-Low Method?

The high-low method is a cost accounting technique that helps identify fixed and variable costs using a limited amount of data. It is particularly useful when there is a lack of historical cost data or when more sophisticated methods, like regression analysis, are not feasible.

Key Takeaways:

• Calculate the variable cost per unit using the identified high and low activity levels.
• Solve for fixed costs.
• Construct a total cost equation based on the high-low calculations.

The High-Low Method Formula

The high-low method formula involves a few simple steps:

Step 1: Calculate Variable Cost per Unit

To calculate the variable cost per unit, you need to determine the difference in costs between the high and low activity levels. Let's consider an example:

Highest cost of production: $1000 at 100 units

Lowest cost of production: $700 at 50 units

Variable cost per unit = (Highest cost - Lowest cost) / (Highest units - Lowest units)

Variable cost per unit = ($1000 - $700) / (100 units - 50 units)

Variable cost per unit = $300 / 50 units

Variable cost per unit = $6 per unit

Step 2: Solve for Fixed Costs

Once you have calculated the variable cost per unit, you can determine the fixed costs. This can be done by subtracting the total variable costs from the total costs at either the high or low activity level.

Let's assume the total cost at the high activity level is $1000 and the variable cost per unit is $6. We can use the formula:

Fixed costs = Total costs - (Variable cost per unit * Total units)

Fixed costs = $1000 - ($6 * 100 units)

Fixed costs = $1000 - $600

Fixed costs = $400

Step 3: Construct Total Cost Equation

Finally, you can construct the total cost equation using the variable cost per unit and fixed costs:

Total cost = Fixed costs + (Variable cost per unit * Number of units)

For example, if you have 75 units, the total cost would be:

Total cost = $400 + ($6 * 75 units)

Total cost = $400 + $450

Total cost = $850

Limitations of the High-Low Method

While the high-low method is a useful technique, it does have its limitations. Some of the limitations include:

• The high-low method assumes a linear relationship between costs and activity levels, which may not always be accurate.
• It requires a limited amount of data, which may not provide a comprehensive understanding of cost behavior.
• Outliers or extreme values can significantly impact the results.

Conclusion

The high-low method is a valuable tool in cost accounting that helps separate fixed and variable costs. By understanding the high-low method formula and its limitations, businesses can make more informed decisions regarding cost management and pricing strategies.