High-Low Method
The High-Low Method is a simple yet effective technique used in accounting to predict cost behavior by examining the cost levels at the highest and lowest activity levels. This method involves plotting the cost data against the activity levels, drawing a straight line through the highest and lowest points, and using this line to understand and predict the cost behavior.
Definition
The High-Low Method is used to estimate fixed and variable components of a cost, by considering the costs at the highest and lowest activity levels within a dataset. By doing so, it aims to establish a cost behavior formula that can be applied to predict future costs at various activity levels.
Detailed Explanation
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Data Collection: Gather data on total costs and corresponding activity levels for a certain period.
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Identify High and Low Points: Identify the periods with the highest and lowest activity levels.
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Calculate Variable Costs: Compute the variable cost per unit (VCU) using the formula:
\[ \text{Variable Cost per Unit (VCU)} = \frac{\text{Cost at High Activity Level} - \text{Cost at Low Activity Level}}{\text{High Activity Level} - \text{Low Activity Level}} \]
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Calculate Fixed Costs: Determine the fixed cost (FC) using either the high or low activity level data:
\[ \text{Fixed Cost (FC)} = \text{Total Cost} - (\text{VCU} \times \text{Activity Level}) \]
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Develop Cost Function: Formulate the cost behavior equation:
\[ \text{Total Cost} = \text{Fixed Cost} + (\text{Variable Cost per Unit} \times \text{Activity Level}) \]
Examples
Example 1: If a company has total costs of $10,000 at an activity level of 2,000 units (highest) and $4,000 at an activity level of 1,000 units (lowest), the VCU would be:
\[ \text{VCU} = \frac{10,000 - 4,000}{2,000 - 1,000} = \frac{6,000}{1,000} = 6 \]
Then, using the high activity point to calculate the fixed cost:
\[ \text{Fixed Cost} = 10,000 - (6 \times 2,000) = 10,000 - 12,000 = -2,000 \]
Example 2: For a service company with a cost of $15,000 for 1,500 services (highest) and $7,500 for 750 services (lowest), VCU is:
\[ \text{VCU} = \frac{15,000 - 7,500}{1,500 - 750} = \frac{7,500}{750} = 10 \]
Fixed Cost can be calculated at the low activity level:
\[ \text{Fixed Cost} = 7,500 - (10 \times 750) = 7,500 - 7,500 = 0 \]
Frequently Asked Questions (FAQs)
Q: What are the limitations of the High-Low Method?
A: The primary limitation is its simplicity, as it uses only two data points to predict the cost behavior, making it less accurate than more sophisticated methods and potentially ignoring fluctuations in data.
Q: When is the High-Low Method appropriate to use?
A: It is best used in situations where quick, initial cost estimations are needed, and when the cost behavior is relatively linear over the short period being studied.
Q: How does the High-Low Method compare with regression analysis?
A: Regression analysis is more accurate as it considers all data points and fits the best possible line, rather than just the highest and lowest points.
Related Terms
- Fixed Costs: Costs that do not change with the level of activity.
- Variable Costs: Costs that vary directly with the level of production or activity.
- Cost Behavior Analysis: The study of how costs change in relation to varying levels of activity.
Online Resources
- Investopedia: High-Low Method
- AccountingTools: High-Low Method
- Corporate Finance Institute: High-Low Method
Suggested Books for Further Studies
- Cost Accounting: A Managerial Emphasis by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
- Managerial Accounting by Ray H. Garrison, Eric Noreen, and Peter Brewer
- Accounting Principles by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
Accounting Basics: “High-Low Method” Fundamentals Quiz
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