When using the high-low method, the two observations used are the high and low observations of the

A technique used in cost accounting to split mixed costs into fixed and variable costs

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.

High-Low Method Formula

The formula for developing a cost model using the high-low method is as follows:

Once the variable cost per unit is determined:

Fixed cost = Highest activity cost – (Variable cost per unit x Highest activity units)

or

Fixed cost = Lowest activity cost – (Variable cost per unit x Lowest activity units)

The resulting cost model after using the high-low method would be as follows:

Cost model = Fixed cost + Variable cost x Unit activity

Example of the High-Low Method

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).

He anticipates that the number of guests in September will be 3,000. Given the dataset below, develop a cost model and predict the costs that will be incurred in September.

Using the high-low method:

Note: It is important to choose the high-low values from the units (i.e., number of guests) and not the total costs. The number of units drives the total costs. For example, notice that the highest total cost is $454,255, which corresponds to an activity level of 4,323. However, the correct high-low values are from the independent variable (the variable that predicts the costs). In such a case, the high and low will be 4,545 number of guests in May (total costs: $371,225) and 1,500 number of guests in January (total costs: $143,000).

Given the variable cost per number of guests, we can now determine our fixed costs.

Using the high activity cost:

Fixed cost = $371,225 – ($74.97 x 4,545) = $30,486.35

Using the low activity cost:

Fixed cost = $105,450 – ($74.97 x 1,000) = $30,480

Using either the high or low activity cost should yield approximately the same fixed cost value. Note that our fixed cost differs by $6.35 depending on whether we use the high or low activity cost. It is a nominal difference, and choosing either fixed cost for our cost model will suffice.

Cost model for hotel = $30,480 + $74.97 x No. of guests

Therefore, the anticipated costs for September would be:

September costs = $30,480 + $74.97 x 3,000 = $255,390

Advantages of the High-Low Method

The high-low method is an easy way to segregate fixed and variable costs. By only requiring two data values and some algebra, cost accountants can quickly and easily determine information about cost behavior. Also, the high-low method does not use or require any complex tools or programs.

Disadvantages of the Method

Due to the simplicity of using the high-low method to gain insight into the cost-activity relationship, it does not consider small details such as variation in costs. The high-low method assumes that fixed and unit variable costs are constant, which is not the case in real life. Because it uses only two data values in its calculation, variations in costs are not captured in the estimate.

Another drawback of the high-low method is the ready availability of better cost estimation tools. For example, the least-squares regression is a method that takes into consideration all data points and creates an optimized cost estimate. It can be easily and quickly used to yield significantly better estimates than the high-low method.

Related Readings

Thank you for reading CFI’s guide to High-Low Method. To keep advancing your career, the additional CFI resources below will be useful:

Methods used to estimate the amounts of fixed and variable costs

The high low method and regression analysis are the two main cost estimation methods used to estimate the amounts of fixed and variable costs. Usually, managers must break mixed costs into their fixed and variable components to predict and plan for the future.

Learn more in CFI’s Math for Corporate Finance Course.

The high low method uses a small amount of data to separate fixed and variable costs. It takes the highest and lowest activity levels and compares their total costs. On the other hand, regression analysis shows the relationship between two or more variables. It is used to observe changes in the dependent variable relative to changes in the independent variable.

High Low Method

The high low method determines the fixed and variable components of a cost. It can be applied in discerning the fixed and variable elements of the cost of a product, machine, store, geographic sales region, product line, etc.

For example, in the production cost of a product, fixed costs may comprise employee’s wages and rental expenses, whereas variable costs include costs incurred in purchasing raw materials.

Formula

The high low method splits the variable and fixed components of mixed costs. The formulas for each component are as follows:

Where:

Y2 is the cost at the highest activity level

Y1 is the cost at the lowest activity level

X2 is the number of units at the highest activity level

X1 is the number of units at the lowest activity level

Once the variable cost has been calculated, the fixed cost can be derived by subtracting the total variable cost from the total cost. This is represented by the following formula:

Fixed Cost = Y2 – bX2

or

Fixed Cost = Y1 – bX1

Where:

b is the variable cost

Example

Company ABC is a manufacturer of pharmaceuticals. The company wants to estimate the amount of overhead costs that it will incur in April, given that the company plans to make 8,000 units in that month. Following are the figures from January to March:

Using the variable cost formula above, where:

Y2 = $30,000

Y1 = $25,000

X2 = 6,000

X1 = 4,000

Therefore:

Fixed Cost = $30,000 – (2.5 x $6,000) = $15,000

or

Fixed Cost = $25,000 – (2.5 x $4,000) = $15,000

Projected variable cost for the month of April is calculated as follows:

= 2.5 x $8,000

= $20,000

Total cost = Fixed cost + Variable cost

= $15,000 + $20,000

= $35,000

Learn more in CFI’s Math for Corporate Finance Course.

Advantages of High Low Method

Using the high low method offers the following benefits:

Easy to use

The high-low method only requires the cost and unit information at the highest and lowest activity level to get the required information. Managers can implement this technique with ease since it does not require any special tools.

High accuracy with stable costs

The high low method can be relatively accurate if the highest and lowest activity levels are representative of the overall cost behavior of the company. However, if the two extreme activity levels are systematically different, then the high low method will produce inaccurate results.

Disadvantages of High Low Method

The high low method comes with the following disadvantages:

May be Unreliable

The method does not represent all the data provided since it relies on just two extreme activity levels. Those activity levels may not be representative of the costs incurred, due to outlier costs that are higher or lower than what the organization incurs in other activity levels.

Does not account for inflation

The high low method excludes the effects of inflation when estimating costs.

Regression Analysis

In contrast to the High Low Method, Regression analysis refers to a technique for estimating the relationship between variables. It helps people understand how the value of a dependent variable changes when one independent variable is variable while another is held constant. Regression analysis is used in forecasting future data. The two main types of regression analysis are linear regression and multiple regression.

Linear regression

Linear regression is a method that studies the relationship between continuous variables. The variables are plotted on a straight line. The linear regression can be calculated using the following formula:

Y = a + bX + ⋴

Where:

Y is the dependent variable

X is the independent variable

b is the slope of the regression line

a is the intercept of the regression line

⋴ is the regression residual

From the formula above, we can deduce that the value of Y is dependent on the value of X, while the value of b shows the changes in Y every time the value of X changes. Meaning, if b equals 0.5, it means that every time X increases or increases by a specific value, the value of Y increases or decreases by that value. On the other hand, when X=0, the value of “a” equals the value of Y.

Assumptions of Linear Regression

• The relationship between dependent variable Y and independent variable X is linear in the slope and intercept ‘a’ and ‘b,’ respectively.
• Independent variable X is not random.
• The value of the error term ⋴ is 0 and is constant for all observations.

Multiple Regression

Multiple regression is a statistical technique that predicts the value of one variable using the value of two or more independent variables. Once each of the independent variables has been determined, they can be used to predict the amount of effect that the independent variables have on the dependent variable. The effect is represented on a straight line to approximate each of the data points.

Learn more in CFI’s Math for Corporate Finance Course.

Formula

The formula for multiple regression is as follows:

Y1= B0 + B1x1 + b2x2+ ………..bnxn + ⋴

Where:

Y1 is the predicted value of the dependent variable

B0 is the intercept

B1, b2 … bn are the regression coefficient

x1, x2, …… xn are the independent variables

⋴ is the regression residual

Assumptions of Multiple Regression

• There is a linear relationship between dependent and independent variables.
• Y1 observations are selected independently and randomly from the population.
• Independent variables are not highly correlated with each other.
• The regression residual shows a mean of 0 and variance of 0.

Related Readings

Thank you for reading CFI’s comparison of the High Low Method and Regression Analysis. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: