High Low Method- Slitting The Smith Company’s Mixed Cost

High Low Method- Slitting The Smith Company’s Mixed Cost

Introduction

Cost is one thing that is very important to consider in the management of a business entity. This is because the cost of a company determines the level of profitability that a company is to enjoy. It is worth noting that the cost of a company is usually in two parts; variable costs and fixed costs. There are several techniques which are used in splitting the mixed cost of a business entity into variable and fixed components. This technique is known to be easy to use, since it does not involve complex processes. An important point to note regarding this method of splitting the mixed cost of ca company into variable and fixed components is that it only focuses on the high and low levels of activity (Financial Accounting for Management: An Analytical Perspective, Pearson Education India (Elton, Gruber, Brown, & Goetzmann, 2009). The levels of activities between the highest and lowest are usually ignored since they do not form part of the formulas input components.

The formulas for the High Low Method

The formulae for calculating the variable cost is as follows

 

Variable Cost per Unit =

y2 − y1
x2 − x1

Where;

y2 = total cost at highest level of activity;
y1 = total cost at lowest level of activity;
x2= the number of units/labor hours etc. at highest level of activity; while
x1 = the number of units/labor hours etc. at lowest level of activity

In the case of The Smith Company

Variable cost per unit=14,940-11,200 = 3,740=  $1.29

10,000-7,100      2,900

The process of calculating the total fixed cost of producing a certain number of units in a company is usually the easiest part of this formula. The total fixed cost of producing a certain number of units in a company is obtained by subtracting the total variable cost from the total cost of production (Gupta, 2008). In the case of the Smith Company, the total fixed cost is as follows;

At 10,000 level of units production, the total variable cost= 10,000*1.29=$12,900

The total cost of producing the 10,000 at The Smith Company= $14,940

Therefore;

The Total fixed cost of the company=$14,900-$12,900

Therefore;

The total Fixed Cost for The Smith Company=$2,040

Therefore, for 8,000 the variable cost= 8,000*1.29=10,320

The Fixed Cost of the Company $2,040

Therefore, the total cost for producing 8,000 units for The Smith Company =The Fixed cost for producing 8,000 units+ The Variable cost for Producing 8,000 units

Total Cost=10,320+2,040

=$12,360

Criticisms of the High-Low Method of Splitting mixed Cost

Even though this method is known to be simple and easy to understand, critics have argued that it is not reliable. This makes it less used as compared to the other methods of estimating the total fixed and total variable costs of a company. The other methods which are commonly used include the scatter-graph method and least-squares regression method. Secondly, this method of splitting mixed cost is criticized for ignoring some data points (Correia, Flynn, Uliana, & Wormald, 2012). This is because the highest and lowest levels used may not represent the actual regression in the production costs. This may end up giving misleading results from the calculation. Once this takes place, the relationship between the cost and production for the company is not reflected well. The high low method is also criticized because of its strong reliance on past information. This means that whenever such information is not available, then the method is not applicable. Additionally, for new companies or businesses, whose past data is not available, the method cannot be used.

 

References

Correia, C., Flynn, D., Uliana, E., & Wormald, M. (2012). Financial Management. Juta and Company Ltd.

Elton, J., Gruber, J., Brown, J. & Goetzmann, N. (2009) Modern Portfolio Theory and Investment Analysis, John Wiley & Sons.

Gupta, A. (2008). Financial Accounting for Management: An Analytical Perspective, Pearson Education India.

 

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