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In accounting and finance, the fixed and variable parts of a cost function are estimated using the high-low method. For the purpose of calculating the overall variable cost and the fixed cost component, the procedure entails comparing the highest and lowest levels of activity.
A business must first determine the times when activity was highest and lowest, as well as the overall costs incurred during those times, before applying the high-low approach. The procedure then entails figuring out the variable cost per unit by dividing the variation in total costs by the variation in activity level between the two periods. It is possible to estimate the variable component of costs for additional activity levels once the variable cost per unit has been established.
The fixed cost component is then calculated by subtracting the entire variable cost from the overall cost for the high or low period. The fixed cost component can then be used to predict the fixed portion of expenses for other activity levels.
The high-low approach is a useful resource for cost assessment when data is scarce or more involved procedures are impracticable. It should be emphasized that the high-low method assumes a linear relationship between activity and costs, which may not always be the case in reality. So, it's important to use caution and other procedures to check the predictions made by the high-low method.
