The High-Low Method in Accounting
Companies face a variety of costs in the operation of their business. These costs behave in different ways. Fixed costs remain the same throughout the year; variable costs change as the activity level changes. Higher activity levels increase the total variable costs. Mixed costs contain a fixed component and a variable component to the cost. Examples of mixed costs include telephone expenses, which include both a fixed access charge and a usage rate per call. Companies use the high-low method to determine how much of a mixed cost is fixed and how much is variable.
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Information Gathering
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The first step in using the high-low method is to identify the mixed cost to analyze. Once you have identified the specific cost, gather the relevant information for that mixed cost. Then record the production level and the mixed cost for each month throughout the year.
Identify High And Low Points
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Review the list, marking the month where the highest production occurred and the month where the lowest production occurred.
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Calculate Variable Cost
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To calculate the variable cost, first calculate the difference in production between the two marked months.Then, calculate the difference in cost between those two months. Divide the total cost difference by the total production difference. This amount provides the variable cost per unit for each month.
Calculate Fixed Cost
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To calculate the fixed cost, you must first calculate the total variable cost for the lowest month. Take the variable cost per unit, and multiply it by the lowest production volume of the year. The total variable cost is subtracted from the total mixed cost for that month. The remaining amount equals the fixed cost per month.
Purpose
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Companies split mixed costs into their fixed and variable components for several reasons. Companies who use flexible budgets need to identify the variable expenses that adjust with changes in activity levels. Flexible budgets allow the company to account for the impact activity level changes have on expenses. Variable costs are also considered when calculating selling prices. Some companies determine selling prices using variable costing, which considers all the variable costs and sets the selling price high enough to cover them. The difference between the selling price and the variable costs helps recover the fixed costs, and contributes to profit. Mixed costs need to be split into their fixed and variable components in order to use flexible budgets or variable costing.
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