The high-low method is a simple technique for computing the variable cost rateand the total amount of fixed costs that are part of mixed costs. Mixed costs are costs that are partially variable and partially fixed. The cost of electricity used in a factory is likely to be a mixed cost since some of the electricity will vary with the number of machine hours, while some of the cost will not vary with machine hours. Perhaps this second part of the electricity cost is associated with circulating and chilling the air in the factory and from the public utility billing its large customers with a significant fixed monthly charge not directly tied to the kilowatt hours of electricity used.
The high-low method uses two sets of numbers: 1) the total dollars of the mixed costs occurring at the highest volume of activity, and 2) the total dollars of the mixed costs occurring at the lowest volume of activity. It is assumed that at both points of activity the total amount of fixed costs is the same. Therefore, the change in the total costs is assumed to be the variable cost rate times the change in the number of units of activity. Prior to using the high-low method, it is important to plot or graph all of the data available to be certain that the two sets of numbers being used are indeed representative.
To illustrate the high-low method, let's assume that a company had total costs of electricity of $18,000 in the month when its highest activity was 120,000 machine hours. (Be sure to match the dates of the machine hours to the electric meter reading dates.) During the month of its lowest activity there were 100,000 machine hours and the total cost of electricity was $16,000. This means that the total monthly cost of electricity changed by $2,000 when the number of machine hours changed by 20,000. This indicates that the variable cost rate was $0.10 per machine hour.
Continuing with this example, if the total electricity cost was $18,000 when there were 120,000 machine hours, the variable portion is assumed to have been $12,000 (120,000 machine hours times $0.10). Since the total electricity cost was $18,000 and the variable cost was calculated to be $12,000, the fixed cost of electricity for the month must have been the $6,000. If we use the lowest level of activity, the total cost of $16,000 would include $10,000 of variable cost (100,000 machine hours times $0.10) with the remainder of $6,000 being the fixed cost for the month.