High-Low Method

High-Low method is one of the several techniques used to split a mixed cost into its fixed and
variable components (see cost classifications). Although easy to understand, high low method is
relatively unreliable. This is because it only takes two extreme activity levels (i.e. labor hours,
machine hours, etc.) from a set of actual data of various activity levels and their corresponding
total cost figures. These figures are then used to calculate the approximate variable cost per unit
(b) and total fixed cost (a) to obtain a cost volume formula:
y = a + bx

High-Low Method Formulas

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:
y2 y1
Variable Cost per Unit =
x2 x1

Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity

The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost
change in number of units produced).

Total Fixed Cost

Total fixed cost (a) is calculated by subtracting total variable cost from total cost, thus:
Total Fixed Cost = y2 bx2 = y1 bx1

Example
Company wants to determine the cost-volume relation between its factory overhead cost and
number of units produced. Use the high-low method to split its factory overhead (FOH) costs into
fixed and variable components and create a cost volume formula. The volume and the
corresponding total cost information of the factory for past eight months are given below:
Month Units FOH
1 1,520 $36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800
Solution:
We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 $38,000) (3,000 1,250) = $12 per unit
Total Fixed Cost = $59,000 ($12 3,000) = $38,000 ($12 1,250) = $23,000
Cost Volume Formula: y = $23,000 + 12x

Least-Squares Regression Method

Least-squares linear regression is a statistical technique that may be used to estimate the total
cost at the given level of activity (units, labor/machine hours etc.) based on past cost data. It
mathematically fits a straight cost line over a scatter-chart of a number of activity and total-cost
pairs in such a way that the sum of squares of the vertical distances between the scattered points
and the cost line is minimized. The term least-squares regression implies that the ideal fitting of
the regression line is achieved by minimizing the sum of squares of the distances between the
straight line and all the points on the graph.

Assuming that the cost varies along y-axis and activity levels along x-axis, the required cost line
may be represented in the form of following equation:

y = a + bx

In the above equation, a is the y-intercept of the line and it equals the approximate fixed cost at
any level of activity. Whereas b is the slope of the line and it equals the average variable cost per
unit of activity.

Formulas
By using mathematical techniques beyond the scope of this article, the following formulas to
calculate a and b may be derived:
Unit Variable Costbnxyxynx2x2Unit Variable Cost=b=nxy-x.ynx2-x2

Total Fixed CostaybxnTotal Fixed Cost=a=y-bxn

Where,
n is number of pairs of unitstotal-cost used in the calculation;
y is the sum of total costs of all data pairs;
x is the sum of units of all data pairs;
xy is the sum of the products of cost and units of all data pairs; and
x2 is the sum of squares of units of all data pairs.
The following example based on the same data as in high-low method tries to illustrate the usage
of least squares linear regression method to split a mixed cost into its fixed and variable
components:

Example
Based on the following data of number of units produced and the corresponding total cost,
estimate the total cost of producing 4,000 units. Use the least-squares linear regression method.

Month Units Cost

1 1,520 $36,375

2 1,250 38,000

3 1,750 41,750

4 1,600 42,360
 Month Units Cost

5 2,350 55,080

6 2,100 48,100

7 3,000 59,000

8 2,750 56,800

Solution:
x y x2 xy

1,520 $36,375 2,310,400 55,290,000

1,250 38,000 1,562,500 47,500,000

1,750 41,750 3,062,500 73,062,500

1,600 42,360 2,560,000 67,776,000

2,350 55,080 5,522,500 129,438,000

2,100 48,100 4,410,000 101,010,000

3,000 59,000 9,000,000 177,000,000

2,750 56,800 7,562,500 156,200,000

16,320 377,465 35,990,400 807,276,500

We have,
n = 8;
x = 16,320;
y = 377,465;
x2 = 35,990,400; and
xy = 807,276,500

Calculating the average variable cost per unit:

b8807,276,50016,320377,465835,990,40016,320213.8b=8807,276,500-
16,320377,465835,990,400-16,320213.8

Calculating the approximate total fixed cost:

a377,46513.807816,320819,015a=377,465-13.807816,320819,015

The cost-volume formula now becomes:

y = 19,015 + 13.8x

At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8 4,000].

Written by Irfanullah Jan