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Fixed and Variable Costs
It is important for an enterprise to distinguish between costs that are fixed at the same level in each period, and those that are variable according to the level of output. The correct measurement of the levels of fixed and variable costs enable an enterprise to operate the appropriate system of costing. For example, if the enterprise employs a system of marginal costing, the variable costs are deducted from earnings to determine the contribution made to covering the fixed costs. In order to operate this system, the enterprise must have some clarity as to the amounts of the fixed and variable costs.
The reality is not always as straightforward as this. Certain costs do not behave precisely as the theory requires. Although direct labor is normally treated as a variable cost, this may not always be strictly the case. Where output falls, the enterprise may need to continue to pay the same amount of wages to direct labor so as to comply with employment contracts or the labor laws. It may not be possible to lay off workers without pay during times of low demand and low output.
Certain costs are fixed at certain levels of output, but tend to increase by steps as the output increases. An example is rent paid for factory premises. As output rises to a certain level, a further factory may need to be rented so as to increase production further. At that particular level of output, therefore, the rent increases by a large step, and then remains at that greater level, until the new factory is operating at full capacity and additional premises need to be rented.
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Another problem encountered by business enterprises is that some costs are paid to the same supplier, but have a fixed and a variable element. The fixed and variable elements of these mixed costs may not be apparent from the supplier's invoice, and the business, therefore, needs to find a method of separating out the fixed and variable elements of the mixed costs. It is quite common to find contracts that contain a basic fixed fee, combined with a variable charge, based on the amount of use of the asset in a period. Although the fixed and variable elements may be clearly stated on the supplier's invoice, as is generally the case with utility bills, not all invoices contain this level of detail.
Methods are therefore required to separate the fixed and variable element of mixed costs, so these elements may be correctly treated in the enterprise's costing system. The high low method has been devised as a method that can be used quickly, and can arrive at an approximation of the fixed and variable elements. The business looks at the highest and lowest levels of activity in a particular period and looks at the level of costs under the mixed cost category at those two points in time. The difference in the level of the mixed costs, at the two levels of activity, is then compared to the difference in levels of output, to arrive at a figure for the variable cost per unit. This can be used to compute the variable and fixed costs at those levels of activity.
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Example of the High Low Method
For example the Albion Superwidget Corporation wants to quickly analyze its costs. At the level of highest activity (an output of 50,000 units) a particular cost amounted to $1,000,000, and at the level of lowest activity (output of 30,000 units) the cost was $800,000, then the variable cost would be estimated by dividing $200,000 ($1,000,000 - $800,000) by the difference in units produced, which is 20,000 units (50,000 - 30,000).
The variable cost per unit would therefore be estimated at $10. Since at an output of 50,000 units the variable cost element is $500,000 ($10 x 50,000 units), the fixed cost is found by deducting the variable costs from total costs, in other words the fixed cost is $500,000 ($1,000,000 - $500,000). This can be confirmed by looking at the lowest level of output in the period, where the variable costs are $300,000 (30,000 units x $10) and the fixed cost is again calculated to be $500,000 ($800,000 - $300,000).
The Albion Superwidget Corporation uses a marginal costing system, and will therefore use the above information to include the variable cost element in its calculation of the margin available, to cover fixed costs. This illustrates the advantages of the high low method which are its relative simplicity, speed, and ease of calculation.
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Fors and Againsts of the High Low Method in Summary
The high low method is a quick and simple method for estimating the fixed and variable elements of mixed costs. However, it may not be reliable in all situations, as the particular levels of mixed costs at different levels of output could be due to factors other than increases in variable costs, as a result of the increased output. The pricing structure of the mixed costs may be complex, or may have changed during the period, resulting in a misleading conclusion for the enterprise using the high low method. Disadvantages of the high low method include its use of only two values, at two different points in time during the period under review. If the charge for mixed costs at either of these times is anomalous, the result of the exercise will be distorted and meaningless.
Other methods exist that may be more accurate than the high low method. The method of least squares overcomes the disadvantages of the high low method, because it uses a number of different values for the mixed costs, which are plotted on a graph. These points are used to compute a line on the graph, which shows the level of fixed costs at the point where the line intersects the Y axis, and shows the variable costs per unit which can be computed from the slope of the line. This method requires more time than the high low method, but is less liable to be rendered meaningless by an anomalous result.
The high low method should therefore only be used where the available information is restricted and a more accurate method cannot be employed. Although the advantages of the high low method are its speed and simplicity, these advantages are outweighed by the disadvantages, which include its dependence on only a few items of data that may be misleading.
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