Learn how to calculate fixed costs using the high-low method, a technique used to estimate the fixed and variable components of a cost.
fixed cost, high-low method, cost analysis, business, finance, accounting
Introduction
As a business owner, it is essential to know the costs associated with your operations. Fixed costs are one of the most critical components of any business, as they are typically incurred regardless of the level of activity. Fixed costs are expenses that do not change regardless of whether you produce one unit or a million units of a product or service. Examples of fixed costs include rent, salaries, insurance, and taxes.
The high-low method is one technique used to estimate the fixed and variable components of a cost. It is a relatively simple process that involves analyzing the highest and lowest levels of activity and the associated costs. The high-low method can be an effective way to estimate the fixed and variable costs of a business and can help business owners make informed decisions about pricing, production, and profitability.
Step-by-Step Guide to Calculating Fixed Cost with High Low Method
Step 1: Gather Data
The first step in calculating fixed costs using the high-low method is to gather data for the cost incurred for a particular period. This data should include the total cost incurred and the level of activity for that period. For example, if you are analyzing the costs associated with producing a product, you will need to gather data on the total cost of production and the number of units produced for a particular period.
Step 2: Identify the Highest and Lowest Levels of Activity and the Associated Costs
The next step is to identify the highest level of activity and the associated cost and the lowest level of activity and its cost. For example, if the cost incurred in January (highest activity) was $10,000 and the cost incurred in May (lowest activity) was $5,000, then these are the two data points needed for the high-low method.
Step 3: Calculate the Variable Cost per Unit
The third step is to calculate the variable cost per unit by subtracting the cost at the lowest activity level from the cost at the highest activity level and dividing the difference by the change in activity level. Using the example above, the change in activity level was 5,000 units (January’s activity was 10,000 and May’s activity was 5,000), and the change in cost was $5,000. Therefore, the variable cost per unit is $1 ($5,000 divided by 5,000 units).
Step 4: Determine the Fixed Cost
The fourth step is to determine the fixed cost by subtracting the variable cost per unit from the total cost at the highest activity level. Using the example above, the total cost at the highest activity level was $10,000, and the variable cost per unit was $1. Therefore, the fixed cost is $5,000 ($10,000 - ($1 x 10,000 units)).
Step 5: Verify the Results
The fifth step is to verify the results by calculating the total cost at the lowest activity level using the variable cost per unit and the fixed cost. Using the example above, the total cost at the lowest activity level would be $10,000 (($1 x 5,000 units) + $5,000 fixed cost), which matches the actual cost incurred in May.
Step 6: Repeat the Process
The final step is to repeat the process with additional data points to ensure consistency of results. By analyzing multiple data points, you can ensure that the results are accurate and can be used to make informed business decisions.
Conclusion
Calculating fixed costs using the high-low method is a relatively simple process that can help business owners estimate the fixed and variable components of a cost. By analyzing the highest and lowest levels of activity and the associated costs, business owners can make informed decisions about pricing, production, and profitability. While the high-low method is a useful tool, it is important to remember that it is an estimate and may not reflect actual costs in all situations. As with any cost analysis, it is important to review and update your estimates regularly to ensure that they remain accurate and relevant to your business.
Learn how to calculate fixed costs using the high-low method, a technique used to estimate the fixed and variable components of a cost.
fixed cost, high-low method, cost analysis, business, finance, accounting
