Effortlessly Estimate Costs with the High-Low Method: A Straightforward Technique

The High-Low method is a cost estimation technique that is used to estimate the fixed and variable components of a cost function. The method is based on the idea that the total cost of a given activity can be broken down into two parts: a fixed cost, which does not change with the level of activity, and a variable cost, which does change with the level of activity.

How the High-Low Method Works

The High-Low method involves identifying the highest and lowest levels of activity for a particular cost item and the corresponding total cost at those levels. The variable cost is then calculated by dividing the difference in total cost by the difference in activity level, while the fixed cost is estimated as the total cost at the low level of activity minus the variable cost at that level.

An Example of the High-Low Method

For example, let’s say a company has two years of data on the total cost of electricity and the number of units produced. In year 1, the company produced 10,000 units and the total cost of electricity was $5,000. In year 2, the company produced 20,000 units and the total cost of electricity was $9,000.

Using the High-Low method, we would first identify the highest and lowest levels of activity, which in this case are 20,000 units and 10,000 units. We would then calculate the difference in total cost ($9,000 – $5,000 = $4,000) and the difference in activity level (20,000 – 10,000 = 10,000). The variable cost per unit of activity is then calculated as $4,000 / 10,000 = $0.40/unit.

Finally, we can estimate the fixed cost, by taking the total cost of the low activity level and subtracting the variable cost of the low activity level. In this case, the total cost at the low activity level is $5,000 and the variable cost at that level is $0.40/unit x 10,000 units = $4,000, thus, the fixed cost would be $5,000 – $4,000 = $1,000

Limitations of the High-Low Method

It’s important to note that, this method is only useful when there’s a relatively small range of activity and when variable costs are linear. Also, this method assumes that the two chosen activity levels represent the extremes of the cost behaviour and that the variable cost per unit of activity is constant over the range of activity.

In conclusion, the High-Low method is a simple and easy-to-use cost estimation technique that can be used to estimate the fixed and variable components of a cost function. The method is based on identifying the highest and lowest levels of activity and the corresponding total cost and then calculating the variable and fixed costs from this information. However, it’s important to remember that this method has some limitations and it’s not always suitable for all kinds of cost behaviours and situations.