The cost accounting technique of the high-low method is used to split the variable and fixed costs. The mathematical expression for the high-low method takes the highest and lowest activity levels from an accounting period. The activity levels are then apportioned depreciation tax shield depreciation tax shield in capital budgeting against the highest and lowest number of units produced. The one element of the total cost then provides the second element by deducting it from the total costs. The Total cost refers to a summation of the fixed and variable costs of production.
The manager of a hotel would like to develop a cost model to predict the future costs of running the hotel. Unfortunately, the only available data is the level of activity (number of guests) in a given month and the total costs incurred in each month. Being a new hire at the company, the manager assigns you the task of anticipating the costs that would be incurred in the following month (September). In cost accounting, the high-low method is a technique used to split mixed costs into fixed and variable costs. Although the high-low method is easy to apply, it is seldom used because it can distort costs, due to its reliance on two extreme values from a given data set. The high-low method is a technique for estimating the fixed and variable components of a mixed cost by analyzing data from high and low activity levels.
However, in many cases, the increased production levels need additional fixed costs such as the additional purchase of machinery or other assets. The higher production volumes also reduce the variable proportion of costs too. The high-low method can be used to identify these patterns and can split the portions of variable and fixed costs. This is the cost that features the high-low method for its calculation.
Construct total cost equation based on high-low calculations above
Management accounting involves decision-making, planning, coordinating, controlling, communicating, and motivating. Similar to management accounting and financial accounting, there is cost accounting to determine the cost of a product. Although easy to understand, high low method may be unreliable because it ignores all the data except for the two extremes.
- It can be argued that activity-cost pairs (i.e. activity level and the corresponding total cost) which are not representative of the set of data should be excluded before using high-low method.
- No, there are other methods apart from the high-low method accounting formula.
- Similarly, a low level of production is deducted from a higher level of production and placed in the denominator.
- The Total cost refers to a summation of the fixed and variable costs of production.
- The end result may not be as accurate as with other approaches but will generally be more than sufficient for most purposes, especially for SMEs.
- Because of the preceding issues, the high-low method does not yield overly precise results.
(Be sure to use the MHs that occurred between the meter reading dates appearing on the bill.) The cost of electricity was $16,000 in the month when its lowest activity was 100,000 MHs. This shows that the total monthly cost of electricity changed by $2,000 ($18,000 vs. $16,000) when the number of MHs changed by 20,000 (120,000 vs. 100,000). In other words, the variable cost rate was $0.10 per machine hour ($2,000/20,000 MHs). This is a very important concept in cost accounting and is very useful in determining fixed and variable costs related to the product, machinery, etc., and is also used in budgeting activities. It is a very simple method to analyze the cost without getting into complex calculations. High low method is the mathematical method that cost accountant uses to separate fixed and variable cost from mixed cost.
Ask a Financial Professional Any Question
Once the variable cost per unit and the fixed costs are calculated, the future expected activity level costs can be determined using the same equation. The company wants to know the rate at which its electricity cost changes when the number of machine hours change. The part of the electric bill that does not change with the number of machine hours is known as the fixed cost. Fixed costs are monthly expenses that do not change depending on the level of production. Rent, depreciation, interest on loans, and lease charges are all examples. A cost that contains both fixed and variable costs is considered a mixed cost.
Which activity is most important to you during retirement?
In other words, as fixed cost is the same in both months, the fixed cost has been eliminated by deduction. Consider the total production cost of February was USD 45,000 and the number of units produced was 10,000. Similarly, the cost of production was USD, 55,000 and the number of units produced was 14,000.
Financial Controller: Overview, Qualification, Role, and Responsibilities
The fixed cost can then be calculated at the specific activity level i.e. either high level or low level of activity. Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable and fixed costs, we have total and fixed costs. The high-low method in accounting is used to separate the elements of variable and fixed costs from the total cost. It makes use of certain techniques to deduct an element of fixed cost from the total cost.
How much are you saving for retirement each month?
It also aids in the control of project costs and the pre-determination of maintenance costs. We can examine long-term company trends and achieve the business goals with proper cost management. Since you have the total cost equation now, you can use this to calculate your cost any month.
Advantages and disadvantages of the high-low method accounting formula
In other words, it is the monetary value of expenditure for supplies, services, etc. For example, if the cost of a liter of milk is $2, the consumer has to spend $2 to acquire a liter of milk. Management accountants work for public companies, private companies, and government offices.