High-Low Method

High-Low method is one of the several techniques used to split a mixed cost into its fixed and variable components (see cost classifications). Although easy to understand, high low method is relatively unreliable. This is because it takes two extreme data points from a set of actual data of various production levels and their corresponding total cost figures. These figures are used to calculate the approximate variable cost per unit (b) and total fixed cost (a) for the cost volume formula: y = a + bx

High-Low Method Formulas

Variable Cost per Unit
Variable cost per unit (b) is calculated using the following formula: Variable Cost per Unit = Where, y2 is the total cost at highest level of activity; y1 is the total cost at lowest level of activity; x2 are the number of units/labor hours etc. at highest level of activity; and x1 are the number of units/labor hours etc. at lowest level of activity In other words, variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost change in number of units produced). y2 y1 x2 x1

Total Fixed Cost

Total fixed cost (a) is calculated using the following formula: Total Fixed Cost = y2 bx2 = y1 bx1

High-Low Method Example

Company wants to construct a cost volume relation between its factory overhead cost and number of units produced. Use the high-low method to analyze its factory overhead (FOH) costs and build a cost volume formula. The volume and the corresponding total cost information of the factory for past eight months are given below: Month 1 2 3 4 5 6 7 8 Solution: We have, x2 = 3,000 x1 = 1,250 y2 = $59,000 y1 = $38,000 Units 1,520 1,250 1,750 1,600 2,350 2,100 3,000 2,750 FOH $36,375 38,000 41,750 42,360 55,080 48,100 59,000 56,800

Variable Cost per Unit = ( $59,000 $38,000 ) ( 3,000 1,250 ) = $12 per unit Total Fixed Cost = $59,000 ( $12 3,000 ) = $38,000 ( $12 1,250 ) = $23,000 Cost Volume Formula: y = $23,000 + 12x Due to its unreliability, high low method is rarely used. The other techniques of variable and fixed cost estimation are scatter-graph method and least-squares regression method.

Scatter Graph Method

Scatter graph method is a graphical technique of separating fixed and variable components of mixed cost by plotting activity level along x-axis and corresponding total cost (mixed cost) along y-axis. A regression line is then drawn on the graph by visual inspection. The line thus drawn is used to estimate the total fixed cost and variable cost per unit. The point where the line intercepts y-axis is the estimated fixed cost and the slope of the line is the average variable cost per unit. Since the visual inspection does not involve any mathematical testing therefore this method should be applied with great care.

Procedure
Step 1: Draw scatter graph
Plot the data on scatter graph. Plot activity level (i.e. number of units, labor hours etc.) along x-axis and total mixed cost along y-axis.

Step 2: Draw regression line

Draw a regression line over the scatter graph by visual inspection and try to minimize the total vertical distance between the line and all the points. Extend the line towards y-axis.

Step 3: Find total fixed cost

Total fixed is given by the y-intercept of the line. Y-intercept is the point at which the line cuts y-axis.

Step 4: Find variable cost per unit

Variable cost per unit is equal to the slope of the line. Take two points (x1,y1) and (x2,y2) on the line and calculate variable cost using the following formula: Variable Cost per Unit = Slope of Regression Line = y2 y1 x2 x1

Example
Company decides to use scatter graph method to split its factory overhead (FOH) into variable and fixed components. Following is the data which is provided for the analysis. Month 1 2 3 4 5 6 7 8 Solution: Units 1,520 1,250 1,750 1,600 2,350 2,100 3,000 2,750 FOH $36,375 38,000 41,750 42,360 55,080 48,100 59,000 56,800

Fixed Cost = y-intercept = $18,000 Variable Cost per Unit = Slope of Regression Line To calculate slop we will take two points on line: (0,18000) and (3500,68000) Variable Cost per Unit = (68000 18000) (3500 0) = $14.286