The accountant at an events management company is preparing a payroll budget based on costs from the past year. Show
The company approves a 5% pay raise at the start of each year and expects that work hours will be 20,000 for the next quarter considering the new hires. Calculate the payroll budget for the new quarter. Step 1: Find the highest and lowest activity values from the units (i.e., work hours) and not the total costs: The highest activity level is 18,000 in Q4, and the lowest activity level is 10,000 in Q1. Step 2: Adjust the payroll cost with the 5% pay increase: Payroll for new year’s Q1 = $300,000 * 105% = $315,000 Step 3: Determine the variable cost per unit: Variable cost per unit = ($540,000 – $315,000) / (18,000 – 10,000) = $28.13 per hour Step 4: Evaluate the fixed cost: Fixed cost = $540,000 – ($28.13 * 18,000) = $33,750 Step 5: Calculate the total variable cost for the new quarter: Total variable cost = $28.13 * 20,000 = $562,600 Step 6: Work out total cost: Payroll budget = Total cost = fixed cost + variable cost = $33,750 + $562,000 = $596,350 Therefore, you can estimate the cost-volume model per work hour for the payroll budget as: Cost model for payroll = $33,750 + $28.13 * x, where x is the number of work hours. The high-low method is an accounting technique used to separate out fixed and variable costs in a limited set of data. It involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level. If the variable cost is a fixed charge per unit and fixed costs remain the same, it is possible to work out the fixed and variable costs by solving the equations. However, users must be cautious of the high-low method. While it is easy to apply, it can distort costs and yield more or less accurate results because of its reliance on two extreme values from one data set. High-low method formulaThe high-low method provides a simple way to split fixed and variable components of combined costs using a few formula steps. First you calculate the variable cost component and fixed cost component, then plug the results into the cost model formula.
Once you have the variable cost per unit, you can calculate the fixed cost.
Then use all the results to calculate the high–low cost using this formula:
High-low method exampleBonnie runs a small car factory in Detroit and needs to know the expected amount of overheads the factory will incur in the next month. Factory overheads cost for the four months prior were as follows:
Bonnie expects to produce 8,000 units in May. Step 1: Identify the highest and lowest activity level The highest activity level is 10,000 units in January (highest activity cost is £60,000) The lowest activity level is 5,500 units in April (lowest activity cost is £55,000) Step 2: Calculate the variable cost per unit Use the formula shown above to work it out: Variable cost per unit = (£60,000 − £55,000) ÷ (10,000 − 5,500) Variable cost per unit = £5,000 ÷ 4,500 = £1.11 per unit Step 3: Calculate the fixed cost Use the formula shown above to work it out: Fixed cost = £60,000 − (£1.11 x 10,00) = £48,900 Step 4: Calculate the total variable cost for the new activity Multiply the variable cost per unit (step 2) by the number of units expected to be produced in May to work out the total variable cost for the month. Total variable cost = £1.11 x 8,000 = £8,880 Step 5: Calculate the total cost Now add the fixed cost (step 3) and variable cost for the new activity (step 4) together to get the total cost of overheads for May. Total cost = £48,900 + £8,880 = £57,780 High-low method limitationsThe high-low method does not consider small details such as variation in costs. It assumes that fixed and unit variable costs are constant, which is not always the case in real life. There are also other cost estimation tools that can provide more accurate results. The least-squares regression method 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. We can helpIf you’re interested in finding out more about fixed overhead volume variance, then get in touch with the financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments. Over 70,000 businesses use GoCardless to get paid on time. Learn more about how you can improve payment processing at your business today. Get StartedLearn More  High Low Method (Table of Contents)
High Low MethodIn 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: Variable Cost Per Unit = (Highest Activity Cost – Lowest Activity Cost) / (Highest Activity Units – Lowest Activity Units) 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. Fixed Cost = Highest Activity Cost – (Variable Cost Per Units * Highest Activity Units) Or Fixed Cost = Lowest Activity Cost – (Variable Cost Per Units * Lowest Activity Units) Let’s take an example to understand the calculation of the High Low Method in a better manner. High Low Method – Example #1Let 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 a 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. 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)
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)
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)
So basically Total cost equation is given by = 23.125x + 1406.25 Where x is the number of burgers sold in a particular month. Since you have the total cost equation now, you can use this to calculate your cost any month. High Low Method – Example #2Let 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)
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)
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)
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.
Similarly For Dec Month Total Cost is calculated as:
ExplanationAlthough 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:
Because of all those limitations, this method is not effective in producing accurate and precise results. Relevance and Uses of High Low MethodAs 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 ArticlesThis has been a guide to the High Low Method. Here we discuss how to calculate the variable cost and fixed cost using a high low method with examples and a downloadable excel template. You may also look at the following articles to learn more – |
When using the high-low method, fixed costs are calculated after variable costs are determined.
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