high point-low point method in cost segmentation method

The high point – low point method is a cost segmentation method in accounting for the separation of the fixed and variable components present in the mixed or semi-variable costs.

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This method is based on the estimation of the fixed part and the variable part of the cost at two different levels of activity; these parts are calculated through an arithmetic interpolation between the two different levels assuming a linear behavior.

The straight line to be estimated represents the Cost-Activity Level relationship. The two points that are selected to define the line are the highest and lowest point of activity. The slope of the line shows the variable rate of cost.

Steps

  1. Select the high and low activity levels for the analyzed period.
  2. Subtract from the highest volume the lowest volume in the activity level.
  3. Subtract from the cost corresponding to the highest level, the cost corresponding to the lowest level.
  4. Calculate the variable rate by dividing the difference in costs for high and low activity levels by the difference in high and low activity levels.
  5. Determine the fixed cost by subtracting from the total cost of any level the part of variable costs (multiplying the variable rate by its level of activity)

The High Point-Low Point Method in Cost Segmentation Method

Introduction

In the world of business, understanding costs and how they are allocated is vital for making informed decisions. Cost segmentation is a method used to classify various costs within a business, allowing for better analysis and decision-making. One popular technique in cost segmentation is the high point-low point method. In this article, we will explore the high point-low point method in cost segmentation and discuss its benefits and limitations.

The High Point-Low Point Method Explained

The high point-low point method is a simple yet effective way to separate fixed and variable costs. It involves choosing two extreme data points from a period of operation, usually the highest and lowest activity levels, and analyzing the corresponding costs.

Analyzing Variable Costs

To determine variable costs using the high point-low point method, we need to compare the costs at the chosen high and low points. Variable costs vary in proportion to the activity level of a business. By subtracting the costs at the low point from the costs at the high point, we can calculate the change in each cost category. This change represents the variable portion of the cost.
For example, let’s consider a manufacturing company. At the high point, the company produced 1,000 units and incurred a total cost of $50,000. At the low point, the company produced 500 units and incurred a total cost of $30,000. The difference in costs ($50,000 – $30,000 = $20,000) represents the variable portion of the cost.

Identifying Fixed Costs

Once we have determined the variable costs, we can calculate the fixed costs using the high point-low point method. Fixed costs remain constant regardless of the activity level of a business. To find the fixed costs, we need to subtract the variable costs we calculated earlier from the total costs at either the high or low point.
Continuing with our previous example, we can subtract the variable cost of $20,000 from the total cost at either the high or low point. Let’s say at the high point, the total cost was $50,000. Subtracting the variable cost, we find that the fixed cost is $30,000 ($50,000 – $20,000).

Benefits of the High Point-Low Point Method

The high point-low point method offers several benefits when it comes to cost segmentation:

  1. Simple and Easy to Implement: This method does not require complex calculations or extensive data analysis, making it accessible to businesses of all sizes.
  2. Cost Effective: The high point-low point method is a cost-effective way to classify costs. It does not require specialized software or resources, making it an affordable option for businesses.
  3. Useful for Decision-Making: By separating fixed and variable costs, businesses can make more informed decisions. For example, understanding the fixed costs can help determine breakeven points or evaluate profitability at different activity levels.
  4. Quick Results: The high point-low point method provides results quickly, allowing businesses to obtain valuable cost information promptly.
  5. Flexibility: This method can be applied to different cost categories, such as manufacturing, overhead, or marketing costs.

Limitations of the High Point-Low Point Method

While the high point-low point method offers benefits, it also has limitations that should be considered:

  1. Dependence on Data Selection: The accuracy of the results obtained using this method heavily relies on the high and low data points selected. If these points are not representative of the broader range of activity, the cost allocations may be distorted.
  2. Assumption of Linearity: The high point-low point method assumes a linear relationship between costs and activity levels. In reality, costs may not always vary in a consistent manner.
  3. Limited Precision: This method provides a rough estimate and may not capture all nuances of cost behavior. It is best suited for quick estimations rather than precise calculations.

Conclusion

The high point-low point method in cost segmentation is a valuable tool for businesses to understand and allocate costs effectively. By separating fixed and variable costs, businesses can make informed decisions, evaluate profitability, and plan for future operations. While it has its limitations, the benefits make this method a popular choice across industries. So, next time you analyze costs, consider implementing the high point-low point method to gain valuable insights and optimize your business operations.

by Abdullah Sam
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