How To Use the High-Low Method To Identify Variable Costs

Have you ever looked at your business expenses and struggled with how to classify them? Many costs aren’t easily categorized as fixed or variable; they blend elements that stay constant with those that change based on your activity.

For a quick and approximate understanding of how a specific mixed cost behaves, the high-low method can help. It’s especially useful when making a time-sensitive decision when more sophisticated tools or data are not readily available. For example, your business receives a rush order for a large quantity of items that are well above your usual production volume.

The high-low method is helpful for understanding the basic concept of cost behavior, showing that fixed costs remain constant regardless of activity levels and variable costs change proportionately with activity. It is a simplified method for estimating variable costs, because it only considers activity level as the driver of cost. When you know the fixed baseline of a cost and the variable rate, you can more accurately forecast what total costs will be at different levels of production or sales.

What is the high-low method?

The high-low method is a quick and easy way to separate mixed costs into their fixed and variable components. A mixed cost is an expense that has both a fixed component and a variable component, which means that part of the cost stays the same regardless of changes in activity levels (like production or sales volume), while the other part fluctuates in direct proportion to activity levels.

The high-low method analyzes the total costs at the highest and lowest levels of activity to estimate the variable component of mixed costs. The highest and lowest levels of activity represent the periods (such as the specific months) that have the maximum and minimum volumes of a specific activity. For example, if you’re looking at monthly production data for a year, it would be the months where the most and the least units were produced.

The high-low method is most commonly applied to overhead costs. Since many overhead costs (like factory utilities, maintenance, or administrative expenses) behave as mixed costs, the high-low method is frequently used to analyze them. That said, the method itself can be applied to any mixed cost, regardless of whether it’s classified as overhead, selling expense, or administrative expense, as long as you have data on total costs and a related activity driver.

How the high-low formula works

Below are the four formulas that make up the high-low method:

1. Variable cost per unit = (Highest activity cost - Lowest activity cost) / (Highest activity units - Lowest activity units)

2. Total variable cost at high point = Variable cost per unit x Highest activity units, or Total variable cost at low point = Variable cost per unit x Lowest activity units

3. Total fixed costs = Total overhead cost at high point - Total variable cost at high point, or Total fixed costs = Total overhead cost at low point - Total variable cost at low point

4. Total overhead cost = Fixed costs + (Variable cost per unit x Activity level)

These formulas guide you through the high-low method, which will help you categorize mixed overhead costs as fixed or variable. First, you’ll review your data to identify the highest and lowest activity costs, along with the corresponding highest and lowest activity units. Using these, you’ll first calculate the variable cost per unit, which represents the incremental cost applied to each additional unit of activity.

Once this is known, you can calculate the total variable cost by identifying either the high or low activity point and subtracting it from the total overhead cost at the same point to figure out the total fixed costs, or the baseline expenses that always stay the same even if activity levels change within the relevant range. After you apply these formulas, you’ll be able to use a clear cost equation that lets you predict total overhead for any given level of activity. This is important for budgeting, pricing decisions, and financial planning.

How to use the high-low method

1. Identify the highest and lowest activity levels and their corresponding costs
2. Calculate the variable cost per unit
3. Calculate the total fixed costs
4. Formulate the cost equation

Let’s use a custom t-shirt company as an example for using the high-low method. The company wants to understand its printing overhead costs (which are mixed costs because they contain both fixed and variable elements) based on the number of shirts printed. Here’s the data for the past six months:

1. Identify the highest and lowest activity levels and their corresponding costs

Based on the data above, the highest activity level was in April, when 1,800 shirts were printed for a corresponding total cost of $7,000. The lowest activity level was in May, when 900 shirts were printed for a corresponding total cost of $5,200.

2. Calculate the variable cost per unit

The change in total cost between the high and low points is attributed solely to the change in variable costs. Note that this is an assumption made to arrive at a rough estimate.

Following the formula, the variable cost per unit is calculated:

Variable Cost per unit = ($7,000 - $5,200) / (1,800 - 900)

= $1,800 / 900

= $2 per shirt

This means that for every additional shirt printed, the cost increases by $2. This is our estimated variable cost per unit.

3. Calculate the total fixed costs

Once you know the variable cost per unit, you can calculate the fixed costs using either the high activity point or the low activity point. Both should yield approximately the same fixed cost, as any minor difference is usually due to rounding.

If you use the high activity point (April), the formula is as follows:

Total variable cost at high point = Variable cost per unit x Highest activity units

= $2 per shirt x $1,800 shirts = $3,600

Total fixed costs = Total overhead cost at high point - Total variable cost at high point

= $7,000 - $3,600 = $3,400

If you use the low activity point (May), here’s the formula:

Total variable cost at low point = Variable cost per unit x Lowest activity units

= $2 per shirt x 900 shirts = $1,800

Total fixed costs = Total overhead cost at low point - Total variable cost at low point

= $5,200 - $1,800 = $3,400

We’ve found that even at the lowest activity level, there’s a base cost of $3,400 that doesn’t change. This is our estimated fixed cost.

4. Formulate the cost equation

The general cost equation is:

Total overhead cost = Fixed costs + (Variable cost per unit x Activity level) 

Total overhead cost = $3,400 + ($2 x Number of shirts printed)

This equation allows you to estimate the total overhead cost for any given number of shirts printed within the relevant range, or the range between the highest and lowest activity levels.

Example application of the cost equation

If the company plans to print 1,300 shirts next month, it can estimate its total overhead cost by following this formula:

Total overhead cost = $3,400 + ($2 x 1,300 shirts)

= $3,400 + $2,600

= $6,000

Advantages of using the high-low method

The high-low method is quick and easy to use. Some other benefits of the high-low method include:

• Simplicity. This is perhaps the biggest advantage. Because the calculations involve basic subtraction and division, it is easy to grasp the concept. 

• Quick estimation. The high-low method can provide a simple calculation without the need for collecting or analyzing a lot of complex data.

• No specialized software required. Specialized software or advanced spreadsheet functions are often required for other types of analysis. The high-low method can be performed with a calculator or a basic spreadsheet. 

Disadvantages of using the high-low method

Despite its simplified method for estimating variable costs, the high-low method has several significant drawbacks that can lead to inaccurate results. Here are the main disadvantages of the high-low method:

• Relies on only two data points. The high-low method only uses the highest and lowest activity levels and their corresponding costs. It overlooks all other data points, which can be problematic if these two extreme points are not representative of typical cost behavior. 

• Assumes a linear relationship. The high-low method assumes that the relationship between activity and total cost is perfectly linear within the relevant range. In reality, cost behavior can be nonlinear. For example, a company might get bulk discounts at higher production levels.

• Certain fixed costs might increase in steps at different activity thresholds. The high-low method doesn’t account for so-called step fixed costs: While some fixed costs remain constant within a certain range of activity, step fixed costs “step up” to a higher fixed level when a certain production threshold is passed.

• Provides a rough estimate, not precise figures. The high-low method provides a quick and often crude estimate of fixed and variable costs. It’s not a good fit for scenarios that require high accuracy, such as financial planning.

Alternative accounting methods

If you’re seeking alternative accounting methods for more robust and accurate cost estimation, here are a few that you might want to consider:

Scatter plot method

This method involves plotting all historical cost data points on a graph with activity level on the X-axis and total cost on the Y-axis. A line of best fit is then drawn through the plotted points. This “eyeballing” method is inherently subjective because it relies on visual judgment and estimation.

Regression analysis

This is the most statistically rigorous and widely preferred method for separating mixed costs. It uses all available data points (not just two extremes) to find the “line of best fit” through a scatter plot of cost and activity data. It differs from the scatter plot method in that it is more precise and relies on statistical calculations.

Account analysis method

This is a qualitative method where experienced accountants or managers review each general ledger account that contains costs and classify them either as fixed, variable, or mixed based on their knowledge of how costs behave. For mixed costs, they then estimate the fixed and variable portions.

Engineering method

This method involves a detailed analysis of the production process to determine how much of each input (materials, labor, machine time) is required to produce a single unit of output. It physically analyzes the relationship between inputs, outputs, and the work involved.

Activity-based costing

While not a direct method for separating variable and fixed costs in the traditional sense, activity-based costing is a more advanced costing method that assigns costs to activities and then to products or services based on their consumption of those activities. It recognizes that many “fixed” overhead costs are actually driven by specific activities (e.g., setting up machines, processing orders) rather than just production volume.