Business needs to forecast costs for the next period to set the basis of budgeting. Costs can be fixed, variable, semi-variable, and stepped fixed costs. Well, it is not that difficult to estimate fixed and variable costs for the next period. We know that fixed costs do not change with the change in activity level. Similarly, the variable cost per unit remains the same so we can multiply it by the estimated activity level, and we will get the estimated total variable cost.
However, the semi-variable cost is a bit complicated to forecast as it contains both fixed as well as variable cost elements. To forecast semi-variable costs, we need to split costs into variable and fixed cost elements. The High-low method is used to split semi-variable costs into fixed and variable elements by considering the highest and lowest values from an available data of costs. In this method, the highest cost in a data set is compared with the lowest cost, and variable and fixed cost is estimated by using an equation (Total cost function).
Steps of high low method
There are four steps to split semi-variable costs into fixed and variable elements. These are explained below:
Select the total costs at highest and lowest activity levels from a given data.
Calculate the variable cost per unit using the following formula:
Calculate the total variable cost at either activity from Step 01 by multiplying the variable cost per unit with the number of units at the respective activity level. Then calculate the total fixed cost by deducting the total variable cost from the total fixed cost. The total cost equation is as follows:
Total Cost = Total Fixed Cost + (Variable cost per unit x Activity Level (units))
Use the variable cost per unit and total fixed cost calculated in Step 02 and Step 03 to estimate the total cost at different activity levels using the cost equation (mentioned above in step 03)
Example – High low method
High low method with stepped fixed cost
Sometimes, the fixed cost in semi-variable cost is a stepped fixed cost. It means it will change after crossing a certain activity level. But we can still use the high-low method to calculate the fixed and variable costs out of semi-variable costs. However, two minor adjustments need to be made in Step 01 and Step 04. Rest of the process is same.
Select the activity levels on which the fixed cost does not change.
Adjust the fixed cost if the activity level in consideration crosses the activity after which a Step-up/Step-Down of fixed cost occurs.