identifying cost relationships high-low method © dale r. geiger 20111

Identifying Cost RelationshipsIdentifying Cost RelationshipsHigh-Low MethodHigh-Low Method

© Dale R. Geiger 2011 1

How can we determine which costs How can we determine which costs are fixed and which are variable?are fixed and which are variable?


Terminal Learning ObjectiveTerminal Learning Objective• Task: Determine the fixed and variable components

of a mixed cost using the High-Low method• Condition: You are a cost advisor technician with

access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors.

• Standard: with at least 80% accuracy• Calculate fixed and variable cost components

from mixed cost data• Describe High-low method


Need for High-Low MethodNeed for High-Low Method

• Fixed and variable components of cost are not always identifiable

• This is especially true in service activities• Sometimes costs aren’t strictly fixed and

variable but mixed or semi-variable• The High-Low Method permits further analysis

by finding an approximate value for variable and fixed costs


High-Low AssumptionsHigh-Low Assumptions

• The relationship between the cost at the highest level of output and the cost at the lowest level of output is linear

• This linear relationship reasonably represents the relationship between costs at other levels of output

• The change in cost from the highest level to the lowest level is due to the change in units from the highest level to the lowest:

• Change in cost / change in units = VC/unit


High-Low CalculationHigh-Low Calculation

• Step 1: Calculate Variable Cost $/unit: • Change in cost / change in units or:

$ at high output – $ at low output # Units at high output – # Units at low output

• Step 2 Calculate Fixed Cost : • Total Cost – Variable Cost or:

$ high output – VC $/unit * # Units high output





• Step 2 Calculate Fixed Cost : • Total Cost – Variable Cost or:

$ high output – VC $/unit * # Units high output





• Step 2 Calculate Fixed Cost : • Total Cost – Variable Cost or:Total $ high output – (VC $/unit * # Units high output)



• Step 3: Develop the cost expression for total cost:

Total cost = VC $/unit * # units + Fixed cost

• This equation can be used for:•Planning for various levels of output•Break even analysis (Day 9)


Check on LearningCheck on Learning

• In the High-Low method, the change in cost from the high level of output to the low level of output is assumed to be caused by…?

• How is fixed cost calculated using the High-Low method?


High-Low ExampleHigh-Low Example

• The purchasing department shows the following activity for the last four months:

Month POs Processed Total CostsJan 100 $2500Feb 80 2200Mar 120 3000April 105 2750


High-Low ExampleHigh-Low Example

• The manager of the purchasing department sees that total costs increase as Purchase Orders increase

• However, he knows that the cost is not strictly variable

• He would like to segregate the variable component of the cost from the fixed cost


Graph of Actual CostsGraph of Actual Costs

Cost at 120 POs = $3000

Cost at 80 POs = $2200

X-Axis represents number of Purchase Orders© Dale R. Geiger 2011

13

Multiple Linear Relationships ExistMultiple Linear Relationships Exist

Essentially any two points on the graph represent a linear

relationship


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High-Low RelationshipHigh-Low Relationship

High-Low Method assumes the relationship between

highest point and lowest point is representative of the whole


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Calculate Unit Variable CostCalculate Unit Variable Cost

Change in Cost / Change in Units=

Total $ at high output – Total $ at low output # Units at high output – # Units at low output

=($3000 – $2200) / (120 units – 80 units)

=$800/40 units

=$20/unit© Dale R. Geiger 2011 16




=($3000 – $2200) / (120 units – 80 units)

=$800/40 units


Calculate Fixed CostCalculate Fixed Cost

Total Cost – Variable Cost =

Total $ high output – VC $/unit * # Units high output=

$3000 – ($20/unit * 120 units)$3000 – ($20/unit * 120 units)

$3000 – ($20 * 120 )$3000 – $2400

= $600



Total Cost – Variable Cost =

Total $ high output – VC $/unit * # Units high output=

$3000 – ($20/unit * 120 units)$3000 – ($20/unit * 120 units)

$3000 – ($20 * 120 )$3000 – $2400

= $600


Express the Mixed Cost RelationshipExpress the Mixed Cost Relationship

• Total Cost = VC $/Unit * # Units + Fixed Cost• Total Cost = $20/Unit * # Units + $600


Using the Cost ExpressionUsing the Cost Expression

• For planning:• If planned output in May is 60 purchase orders,

what is our expected cost?$20/PO * 60 POs + $600 = $1800

• If planned output in June is 130 purchase orders?$20/PO * 130 POs + $600 = $3200



• For comparison and learning• April’s cost of $2750 for 105 POs was higher than

expected. Why?Expected cost = $20/PO * 105 POs + $600 = $2700• January’s cost of $2500 for 100 POs was lower

than expected. Why?Expected cost = $20/PO * 100 POs + $600 = $2600

• What did we do differently? What can we learn?


Check on LearningCheck on Learning

• What might cause a difference between the expected cost using High-Low and the actual cost?


Practical ExercisePractical Exercise



Enter and Filter Data to identify if relationship is reasonably linear

The spreadsheet calculates the Variable and Fixed portions of the cost

Practical ExercisePractical Exercise


identifying cost relationships high-low method © dale r. geiger 20111

Documents

cost change

total cost variable

units fixed cost

cost expression

units high output dale

variable cost components

variable components

high level of output