Identifying Cost Relationships High-Low Method © Dale R. Geiger 20111
How can we determine which costs are fixed and which are variable? © Dale R. Geiger 20112
Terminal Learning Objective Task: Determine the fixed and variable components of a mixed cost using the High-Low method Condition: You are a cost advisor technician with access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors. Standard: with at least 80% accuracy Calculate fixed and variable cost components from mixed cost data Describe High-low method © Dale R. Geiger 20113
Need for High-Low Method Fixed and variable components of cost are not always identifiable This is especially true in service activities Sometimes costs aren’t strictly fixed and variable but mixed or semi-variable The High-Low Method permits further analysis by finding an approximate value for variable and fixed costs © Dale R. Geiger 20114
High-Low Assumptions The relationship between the cost at the highest level of output and the cost at the lowest level of output is linear This linear relationship reasonably represents the relationship between costs at other levels of output The change in cost from the highest level to the lowest level is due to the change in units from the highest level to the lowest: Change in cost / change in units = VC/unit © Dale R. Geiger 20115
High-Low Calculation Step 1: Calculate Variable Cost $/unit: Change in cost / change in units or: $ at high output – $ at low output # Units at high output – # Units at low output Step 2 Calculate Fixed Cost : Total Cost – Variable Cost or: $ high output – VC $/unit * # Units high output © Dale R. Geiger 20116
High-Low Calculation Step 1: Calculate Variable Cost $/unit: Change in cost / change in units or: $ at high output – $ at low output # Units at high output – # Units at low output Step 2 Calculate Fixed Cost : Total Cost – Variable Cost or: $ high output – VC $/unit * # Units high output © Dale R. Geiger 20117
High-Low Calculation Step 1: Calculate Variable Cost $/unit: Change in cost / change in units or: $ at high output – $ at low output # Units at high output – # Units at low output Step 2 Calculate Fixed Cost : Total Cost – Variable Cost or: Total $ high output – (VC $/unit * # Units high output) © Dale R. Geiger 20118
High-Low Calculation Step 3: Develop the cost expression for total cost: Total cost = VC $/unit * # units + Fixed cost This equation can be used for: Planning for various levels of output Break even analysis (Day 9) © Dale R. Geiger 20119
Check on Learning In the High-Low method, the change in cost from the high level of output to the low level of output is assumed to be caused by…? How is fixed cost calculated using the High- Low method? © Dale R. Geiger
High-Low Example The purchasing department shows the following activity for the last four months: MonthPOs ProcessedTotal Costs Jan100 $2500 Feb Mar April © Dale R. Geiger
High-Low Example The manager of the purchasing department sees that total costs increase as Purchase Orders increase However, he knows that the cost is not strictly variable He would like to segregate the variable component of the cost from the fixed cost © Dale R. Geiger
Graph of Actual Costs Cost at 120 POs = $3000 Cost at 120 POs = $3000 Cost at 80 POs = $2200 Cost at 80 POs = $2200 X-Axis represents number of Purchase Orders © Dale R. Geiger
Multiple Linear Relationships Exist Essentially any two points on the graph represent a linear relationship X-Axis represents number of Purchase Orders © Dale R. Geiger
High-Low Relationship High-Low Method assumes the relationship between highest point and lowest point is representative of the whole X-Axis represents number of Purchase Orders © Dale R. Geiger
Calculate Unit Variable Cost Change in Cost / Change in Units = Total $ at high output – Total $ at low output # Units at high output – # Units at low output = ($3000 – $2200) / (120 units – 80 units) = $800/40 units = $20/unit © Dale R. Geiger
Calculate Unit Variable Cost Change in Cost / Change in Units = Total $ at high output – Total $ at low output # Units at high output – # Units at low output = ($3000 – $2200) / (120 units – 80 units) = $800/40 units = $20/unit © Dale R. Geiger
Calculate Unit Variable Cost Change in Cost / Change in Units = Total $ at high output – Total $ at low output # Units at high output – # Units at low output = ($3000 – $2200) / (120 units – 80 units) = $800/40 units = $20/unit © Dale R. Geiger
Calculate Fixed Cost Total Cost – Variable Cost = Total $ high output – VC $/unit * # Units high output = $3000 – ($20/unit * 120 units) $3000 – ($20 * 120 ) $3000 – $2400 = $600 © Dale R. Geiger
Calculate Fixed Cost Total Cost – Variable Cost = Total $ high output – VC $/unit * # Units high output = $3000 – ($20/unit * 120 units) $3000 – ($20 * 120 ) $3000 – $2400 = $600 © Dale R. Geiger
Calculate Fixed Cost Total Cost – Variable Cost = Total $ high output – VC $/unit * # Units high output = $3000 – ($20/unit * 120 units) $3000 – ($20 * 120 ) $3000 – $2400 = $600 © Dale R. Geiger
Calculate Fixed Cost Total Cost – Variable Cost = Total $ high output – VC $/unit * # Units high output = $3000 – ($20/unit * 120 units) $3000 – ($20 * 120 ) $3000 – $2400 = $600 © Dale R. Geiger
Express the Mixed Cost Relationship Total Cost = VC $/Unit * # Units + Fixed Cost Total Cost = $20/Unit * # Units + $600 © Dale R. Geiger
Express the Mixed Cost Relationship Total Cost = VC $/Unit * # Units + Fixed Cost Total Cost = $20/Unit * # Units + $600 © Dale R. Geiger
Using the Cost Expression For planning: If planned output in May is 60 purchase orders, what is our expected cost? $20/PO * 60 POs + $600 = $1800 If planned output in June is 130 purchase orders? $20/PO * 130 POs + $600 = $3200 © Dale R. Geiger
Using the Cost Expression For planning: If planned output in May is 60 purchase orders, what is our expected cost? $20/PO * 60 POs + $600 = $1800 If planned output in June is 130 purchase orders? $20/PO * 130 POs + $600 = $3200 © Dale R. Geiger
Using the Cost Expression For planning: If planned output in May is 60 purchase orders, what is our expected cost? $20/PO * 60 POs + $600 = $1800 If planned output in June is 130 purchase orders? $20/PO * 130 POs + $600 = $3200 © Dale R. Geiger
Using the Cost Expression For comparison and learning April’s cost of $2750 for 105 POs was higher than expected. Why? Expected cost = $20/PO * 105 POs + $600 = $2700 January’s cost of $2500 for 100 POs was lower than expected. Why? Expected cost = $20/PO * 100 POs + $600 = $2600 What did we do differently? What can we learn? © Dale R. Geiger
Using the Cost Expression For comparison and learning April’s cost of $2750 for 105 POs was higher than expected. Why? Expected cost = $20/PO * 105 POs + $600 = $2700 January’s cost of $2500 for 100 POs was lower than expected. Why? Expected cost = $20/PO * 100 POs + $600 = $2600 What did we do differently? What can we learn? © Dale R. Geiger
Using the Cost Expression For comparison and learning April’s cost of $2750 for 105 POs was higher than expected. Why? Expected cost = $20/PO * 105 POs + $600 = $2700 January’s cost of $2500 for 100 POs was lower than expected. Why? Expected cost = $20/PO * 100 POs + $600 = $2600 What did we do differently? What can we learn? © Dale R. Geiger
Using the Cost Expression For comparison and learning April’s cost of $2750 for 105 POs was higher than expected. Why? Expected cost = $20/PO * 105 POs + $600 = $2700 January’s cost of $2500 for 100 POs was lower than expected. Why? Expected cost = $20/PO * 100 POs + $600 = $2600 What did we do differently? What can we learn? © Dale R. Geiger
Check on Learning What might cause a difference between the expected cost using High-Low and the actual cost? © Dale R. Geiger
Practical Exercise © Dale R. Geiger
© Dale R. Geiger Enter and Filter Data to identify if relationship is reasonably linear The spreadsheet calculates the Variable and Fixed portions of the cost
Practical Exercise © Dale R. Geiger