High-Low Method for Cost Estimation

What is the High-Low method used for?

The High-Low method is used for estimating the fixed cost element in a cost equation by analyzing the highest and lowest activity levels and their corresponding costs.

Answer:

The High-Low method is used to estimate the fixed cost element in a cost equation by using the highest and lowest activity levels and their corresponding costs.

The High-Low method is a simple yet effective technique used by businesses to determine the fixed and variable components of a cost. By analyzing the costs at both the highest and lowest levels of activity, companies can better understand the underlying cost structure. In the given example, the High-Low method was applied to power costs based on machine hours.

At the high level of activity in November, 12,000 machine hours were run with power costs amounting to $14,000. Meanwhile, in April, a month of low activity, only 2,000 machine hours were run and power costs totaled $5,000. By calculating the differences in costs and machine hours between these two points, the fixed and variable cost elements can be determined.

To find the estimated fixed cost element of power costs, the first step is to calculate the variable cost per machine hour. This is done by subtracting the power costs at the low activity level from the high activity level, and then dividing by the difference in machine hours.

In this case, the variable cost per machine hour is found to be $0.90. By using this variable cost, the fixed cost element of power costs is then computed by subtracting the variable cost per machine hour multiplied by the number of machine hours from the total power costs at either the high or low level of activity. The result is the estimated fixed cost element of $3,200.

Through the High-Low method, businesses can gain insights into their cost structure, make more accurate financial projections, and improve decision-making processes. It provides a valuable tool for cost estimation and management, helping companies optimize their resources and enhance profitability.