High Low Method (Table of Contents)
High Low Method
In any business, there is 3 types of cost: Fixed Cost, Variable Cost and Mixed Cost (mix of fixed and variable). So, in a very simple language, the high low method is a method which is used to separate fixed and variable cost from the total cost. It compares the highest level of activity and the lowest level of activity and then compares cost at each level. This is a very important concept in cost accounting and is very is useful in determining fixed and variable costs related to the product, machinery, etc. and also used in budgeting activities. It is a very simple method to analyze the cost without getting into any complex calculations.
Formula For High Low Method:
In the high low method, we start with determining variable cost first. The formula for variable cost in this method is given by:
Once we have arrived at variable cost, we can find the total variable cost for both the activities and subtract that value from the corresponding total cost to find a fixed cost.
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Examples of High Low Method (With Excel Template)
Let’s take an example to understand the calculation of High Low Method in a better manner.
High Low Method – Example #1
Let say you have a small business and you sell burgers. For the last 12 months, you have noted down what was the monthly cost and what was the number of burgers sold in the corresponding month. Now you want to use high low method to segregate fixed and variable cost.
Data Table:
Determine the highest and lowest activity point. So the highest activity happened in the month of April and the lowest is in the month of October.
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Variable Cost Per Unit is calculated using the formula given below
Variable Cost Per Unit = (Highest Activity Cost – Lowest Activity Cost) / (Highest Activity Units – Lowest Activity Units)
- Variable Cost Per Unit = ($5,800 – $3,210) / (190 – 78)
- Variable Cost Per Unit = $23.125
For the Highest Activity
Fixed Cost is calculated using the formula given below
Fixed Cost = Highest Activity Cost – (Variable Cost Per Units * Highest Activity Units)
- Fixed Cost = $5,800 – ($23.125 * 190)
- Fixed Cost = $1,406.25
For the Lowest Activity
Fixed Cost is calculated using the formula given below
Fixed Cost = Lowest Activity Cost – (Variable Cost Per Units * Lowest Activity Units)
- Fixed cost = $3,210– ($23.125 * 78)
- Fixed Cost = $1,406.25
So basically Total cost equation is given by = 23.125x + 1406.25
Where x is the number of burgers sold in particular month.
Since you have the total cost equation now, you can use this to calculate your cost any month.
High Low Method – Example #2
Let say you are a manager of a hotel and you are really concerned about the cost of which hotel is incurring and you want to derive a model to predict future cost, based on historical cost. You have collected data for the last 10 months and wants to see the cost for the next 2 months.
Data Table:
Determine the highest and lowest activity point. So the highest activity happened in the month of Jun and the lowest is in the month of March.
Variable Cost Per Unit is calculated using the formula given below
Variable Cost Per Unit = (Highest Activity Cost – Lowest Activity Cost) / (Highest Activity Units – Lowest Activity Units)
- Variable Cost Per Unit = ($3,769,000 – $960,000) / (4210 – 990)
- Variable Cost Per Unit = $872.36 per unit
For the Highest Activity
Fixed Cost is calculated using the formula given below
Fixed Cost = Highest Activity Cost – (Variable Cost Per Units * Highest Activity Units)
- Fixed Cost = $3,769,000 – ($872.36 * 4210)
- Fixed Cost = $96,363.35
For the Lowest Activity
Fixed Cost is calculated using the formula given below
Fixed Cost = Lowest Activity Cost – (Variable Cost Per Units * Lowest Activity Units)
- Fixed cost = $960,000 – ($872.36 * 990)
- Fixed Cost = $96,363.35
Calculation of Total Cost
Total Cost = (Variable Cost Per Unit * x) + Fixed Cost
Where x is the number of guests in a particular month.
So, For Nov Month Total Cost is calculated as:
The result will be as given below.
- Total Cost = ($872.36 * 4200) + $96,363.35
- Total Cost = $3,760,276
Similarly For Dec Month Total Cost is calculated as:
- Total Cost = ($872.36 * 3290) + $96,363.35
- Total Cost = $2,966,429
Explanation
Although the high low method is easy to calculate and helps us in forecasting future costs, it is not very commonly used because it has certain limitations:
- The first limitation is that this method assumes that there is a linear relationship between cost and activity which is not the case always.
- Secondly, it only assumes 2 activity levels and is not the correct representation of the entire data set.
- If there are changes in fixed or variable cost with time, this method does not capture that.
Because of all those limitations, this method is not effective in producing accurate and precise results.
Relevance and Uses of High Low Method
As discussed above, the high low method is very simple, easy to understand and very easy to quickly work around. No complex tools or programming is required to use a high low method. But there are a set of limitations associated with it which reduce the practical application of this tool. We should be really careful while using this tool because it is more prone to give inaccurate results. Reason for that is really simple. Cost is affected by various elements and cannot be effectively predicted using only two variables. Also, after a certain level of production, we need more fixed investment and it is not captured in this model. So one should be really careful using this method.
Recommended Articles
This has been a guide to High Low Method. Here we discuss how to calculate the variable cost and fixed cost using a high low method with examples and downloadable excel template. You may also look at the following articles to learn more –
