Managerial Accounting 5.2.2: Cost Estimation Using High Low Method - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how to use  the high-low method to estimate fixed and  

variable costs. There are some key points here  that I want to make before we move on to the  

example that we'll be using. First of all this  is a quick and easy way to estimate costs.

It's typically used with another more accurate  technique such as the account analysis approach  

or a regression analysis approach, and both of  those are described in separate videos. But this  

method, the high-low method, uses historical cost  information from several different reporting  

periods. It could be monthly information for the  last, over the course the last year, it could be  

last couple of years. Depends on the situation.  But we're using historical cost information from  

several reporting periods to estimate costs. And  using this approach, the high-low method, we pick  

out the highest and lowest activity levels  and we use that information to calculate an  

equation that will help us to determine  our estimate of fixed and variable costs.

This slide shows a summary of the four steps of  the high-low method. We are going to go through  

each of these steps in detail with some data in  the next few slides. But I wanted to give you a  

general idea of what these steps are before we  do that. Step one is where we identify the  

high and low activity levels from the data set,  the historical information, that we will be using.  

Step two is then to take that information and  calculate the variable cost per unit. Step three  

is to calculate the total fixed cost and then  we take that information in step four and plug  

it into this equation Y = f + vX. That is we take  our variable cost per unit that we figured out in  

step two and plug it in here. And we take the total  fixed cost that we determine in step three and we  

plug it in here. Then we have everything we need  to estimate Y given a certain level of activity X.

What we have here is the information we need  to perform step one. That is we're looking at, in  

this example, total production costs by month  and it looks like we have July through June,  

and the level of activity, that is the number of  units produced for each month. Remember step one  

is to identify the high and the low level of  activity. And you see that in red in this chart.  

January shows that we have a low of 2,900 units  produced for the data set that we're looking  

at, and April shows that we have a high of 5,900  units produced. So those are the low  

and high levels of activity and the corresponding  dollar amounts are here as well, for each of those  

levels of activity. So we're going to take that  information, remember this information, into the  

next slide where we're going to perform step  two and calculate the variable cost per unit.

To calculate the variable cost per unit, we are  going to take the cost at the highest level in  

the numerator, minus the cost at the lowest level,  and then we're going to take the highest activity  

level in the denominator, and subtract the lowest  activity level. And that gives us then the, what you  

see here $380,000 minus $200,000 divided by 5,900  units, minus 2,900 units. And again that comes from  

the previous slide. That results in the cost  per unit v, of $60 per unit. And for those math  

aficionados out there, what we're calculating  here essentially, is the slope. We have two data  

points and we are using those two data points  to draw a straight line, if we were looking at  

a graph and from that calculating the slope.  In the old days they used to call this the  

rise, which is the numerator, over the run, the  denominator. So the slope or the variable cost  

per unit in step two is $60. Step three  requires us to calculate the total fixed cost. 

And what we have now, what we know, is the variable  cost per unit, this $60 right here. So we're  

going to plug that into the equation Y = f + vX. 60 is the v part of this, and solve for total  

fixed cost. And really the only way to do that  is to have a value for Y and a value for X.

And so what we're going to do, is we are going to select  either the high or the low activity level, either  

ones fine. And that comes from two slides back. And  plug it in, plug the information for that high or  

low activity level. I used, I happen to use here  the low activity level of $200,000 and 2,900 units.   

So we plug that in Y and X and solve for the total fixed  cost. And what you see here is that the total fixed  

cost is $200,000 minus $174,000, that comes from up  here this $60 times 2,900 units, and we  

get the resulting total fixed cost of $26,000.  So now we have what we need to formulate the  

equation which I'll show you on the next slide.  Step four then is to take the information that  

we have from the first three steps and plug it in  to our equation Y = f + vX. And again some  

textbooks will use different terms here. But we're  essentially doing the same thing across textbooks.  

And that is to state our estimate of mixed costs  using this equation. So what do we know. We know  

that we have $26,000 in total fixed costs, that  came from step three, and we have $60 per unit  

for our variable costs. We plug those numbers in  here and now we can solve for Y, plugging in a  

value for X. So as an example, we might expect in  a future month to produce 4,000 units.

If we want to estimate our total production cost,  because that's what we're focusing on here, is  

monthly production costs, we would plug in 4,000 units for X and then solve for Y.

How we would do that is to take then the $26,000,  total fixed costs, and we would add to that our  

total variable costs, which we calculate  by taking $60 per unit times 4,000 units.

Our total variable costs then would be $240,000,  that's this right here $60 per unit times 4,000  

units, and we would add to that the $26,000 in  fixed costs. And the result would be, the estimate  

would be, $266,000. So to summarize, we took some  historical information for our production facility,  

that is we took monthly production costs, and  we use that information to estimate our total  

monthly fixed costs, related to production  and our variable cost per unit, related to  

production. With that information we can plug in  an expected future production level to estimate  

the production costs for that particular month. And  we said, well what if we produce 4,000 units. Let's  

plug that in and see what the result  is. We did that, we took 4,000 units and multiplied  

it by $60 per unit, added our total fixed cost,  and came up with an estimate in the future of  

$266,000 in production costs, if we produce 4,000  units. There are some potential weaknesses in using  

the high-low method. This approach first of  all only uses the highest and the lowest level  

of activity to establish an estimate of fixed and  variable costs. So if we have 12 months worth of  

data like we did in the example here, that we're  using to estimate our total fixed and variable  

cost per unit. We are only using two data points and  they happen to be the most extreme data points, and

we ignore the other ten data points. So that is  a weakness with the high-low method. If all the  

data points are fairly consistent it's not a  huge problem. But if we have some extremes this  

could really be an issue, because we may be using  data points that do not represent the data set as  

a whole. Sometimes cost accountants will then  throw out the highest and lowest points just  

to get rid of those extremes and then use the  next highest and lowest points. Another way to  

confirm that our results are in the ballpark,  is to use this in conjunction with another  

method. So we might use the regression analysis,  or account analysis, or the scattergraph approach,  

with this to confirm our results. And those  approaches are discussed in separate videos.