Method 2 High low Method The high low method fixes much of the uncertainty in

# Method 2 high low method the high low method fixes

This preview shows page 77 - 81 out of 81 pages.

Method 2: High-low Method The high-low method fixes much of the uncertainty in the scatter diagram approach by only using two data points – the high and low cost data points – and the associated production quantity measurements on the vertical axis - and drawing the “best fit” line through those 2 points. At the point where the line crosses the Total Cost (or vertical) axis, an estimate of the fixed cost
is given. The benefit of this method is that there is no uncertainty as to the high and low level of costs in the data table. The following are the steps for the High-Low method: Step 1 Arrange the information from the high and low periods as below: High-Low Month Cost Production Step 2 Select the month with the high level of activity (and its related total cost), and the low level of activity (and its related total cost). From our data in the example, the high level of activity (production of units) is found in December and the low level of activity is found in January. High level of activity: December 20x1 Total cost: \$58,000 Production: 135,000 units*** *** must use high level of production (activity) on horizontal axis and NOT high level of cost on vertical axis Low level of activity: January 20x1 Total cost: \$41,000 Production: 35,000 units
Total cost difference: \$17,000 Production difference: 100,000 units Step 3 Divide the difference in cost by the difference in activity (units produced) to get the variable cost per unit of activity (units produced here). Variable Cost per unit produced \$17,000/100,000 units =\$.17/unit or conversely Change in cost/change in activity = \$0.17 Step 4 Since there are two data points connected by a straight line extending to the vertical axis, use the following equation here: Total Cost =Variable Cost/unit x units produced) + Fixed Cost Substitute in TC and VC/unit just computed at either the High or Low level of activity, then solve for the Fixed Cost: TC = \$.17/unit (VC)+FC \$58,000 = (\$.17/unit * 135,000 units) + FC \$58,000 = \$22,950 + Fixed Costs Fixed Costs = \$58,000-22,950 = \$35,050 (note: same Fixed Cost estimate occurs at low level of activity)
Step 5 Write the estimated cost equation based on the above computations: TC = (VC/unit *units) + \$FC TC = (\$.17/unit*#of units) + \$35,050 The drawback to this high-low method is that there are only two data points used out of the historical information available. If either of these data points is not representative of the others, (a so called outlier), then we may not have a valid model to estimate the costs based on changes in activity levels. To overcome this possible shortfall, the regression method is sometimes used. Method 3: Least-squares Regression Method The least-squares regression method has the advantage of estimated cost behavior using all of the given data points. It is a statistical method that has many repetitive calculations to “fit” the data to get a fairly accurate estimate of cost behavior.

#### You've reached the end of your free preview.

Want to read all 81 pages?

• Spring '11
• Scott