What is High-low Method in Accounting?
High-low Method is used in Accounting to separate fixed and variable cost element from historical cost that is a mixture of both fixed and variable cost and with the use of the high low formula per unit variable cost is measured by subtracting the cost of lowest activity from the cost of highest activity and dividing the resultant amount from the difference of units of highest activity and the units of lowest activity.
In cost accounting, the high-low method refers to the mathematical technique that is used to separate fixed and variable components that are otherwise part of the historical cost that is mixed in nature i.e. partially fixed and partially variable. The high-low method comprises the highest and the lowest level of activity and comparison of the total costs at each level.
Formula of High-Low Method
Under the high-low method, the variable cost per unit is calculated by initially deducting the lowest activity cost from the highest activity cost, then deducting the number of units at the lowest activity from that of the highest activity and then dividing the former by the latter. Mathematically, it is represented as,
Once the variable cost per unit has been determined, the fixed cost can be calculated either by deducting the product of variable cost per unit and the highest activity units from the highest activity cost or by deducting the product of variable cost per unit and lowest activity units from the lowest activity cost.
Mathematically, it is represented as,
Calculation of the High-low Method in Accounting
The formula for the calculation of variable cost and fixed cost under the high-low method is derived by using the following steps:
- Step 1: Firstly, determine the highest activity units and the lowest activity units from the available costing chart.
- Step 2: Next, determine the corresponding cost of production at the level of highest and level activity units.
- Step 3: Next, deduct the lowest activity cost from the highest activity cost to take out the fixed cost component such that the remaining is the variable component corresponding to the incremental number of units.
Variable cost component = Highest activity cost – Lowest activity cost
- Step 4: Next, the incremental number of units is calculated by deducting the number of units at the lowest activity from that of the highest activity.
Incremental number of units = Highest activity units – Lowest activity units
- Step 5: Next, the variable cost per unit is calculated by dividing the expression in step 3 by the expression in step 4 as shown above.
- Step 6: Next, the fixed cost is calculated either by deducting the product of variable cost per unit and the highest activity units from the highest activity cost or by deducting the product of variable cost per unit and lowest activity units from the lowest activity cost as shown above.
Let us take the example of a company that wants to determine the expected amount of factory overhead cost that it will incur in the upcoming month. The factory overhead cost in the previous three months is as follows:
The company is planning to produce 7,000 units in March 2019 on the back of buoyant market demand. Help the company accountant to calculate the expected factory overhead cost in March 2019 by using the high-low method.
The following are the given data for the calculation of the high-low method.
Therefore, using the above information variable cost per unit can be calculated as,
- Variable cost per unit = ($60,000 – $50,000) / (6,000 – 4,000)
Variable cost per unit will be-
- Variable cost per unit = $5 per unit
Now, the fixed cost can be calculated as,
- Fixed cost = $60,000 – ($5 * 6,000)
Fixed Cost will be –
- Fixed cost = $30,000
Therefore, the expected overhead cost for the month of March 2019 for 7,000 units can be calculated as,
- Total cost = Fixed cost + Variable cost per unit * Number of units
- = $30,000 + $5 * 7,000
Expected Overhead Cost will be-
- Total Cost = $65,000
Therefore, the overhead cost is expected to be $65,000 for the month of March 2019.
Relevance and Uses
It is very important to understand the concept of the high-low method because it is usually used in the preparation of the corporate budget. It is used in estimating the expected total cost at any given level of activity on the basis of the assumption that past performance can be practically used to project cost in the future. The underlying concept of the method is that the change in the total costs is the variable cost rate multiplied by the change in the number of units of activity.
Nevertheless, it has limitations such as, the high-low method assumes a linear relationship between cost and activity which may be over-simplification of cost behavior. Further, the method may be easy to understand, but the high-low method is not considered reliable because it ignores all the data except for the two extreme ones.
This has been a guide to the High-Low Method in Accounting and its Definition. Here we discuss the formula to create a high-low cost model and calculate the variable cost and fixed cost per unit along with the practical examples and downloadable excel sheet. You can learn more about financing from the following articles –