Weakness of the High-Low Method of Accounting

Basics of the High-Low Method

The high-low method of accounting is a tool used to evaluate the costs of increasing production. It's designed to separate fixed costs, expenses that remain the same no matter what the production level, from variable costs, which are change with the number of units produced or the number of customers served. In the high low method, costs are determined at the highest level of activity and at the lowest level of activity. The difference in cost is then divided by the difference in activity to determine the variable cost per unit. This cost is then multiplied by the total activity level to determine the total variable cost. Total variable cost is subtracted from the actual total cost to determine the fixed cost.

The high-low method could run into problems if the highest and lowest costs are not representative of the actual cost regression. In other words, if a line is drawn from the cost at highest point of activity to the cost at the lowest, the costs at other points should generally land somewhere near this line. If they substantially deviate from the line, it's likely that the high-low method is not adequate to provide an accurate picture of the cost-production relationship.

Calculating the high-low method relies on past cost records. This presents a couple of major weaknesses. The most obvious is that the high-low method cannot be calculated if this past data is not actually available. For this reason, start-ups and relatively young businesses may not be able to use the high-low method of accounting. In addition, as with most financial statements and projects, past performance is not necessarily an accurate predictor of future market conditions.

To better understand the shortcomings of the high-low method, it is important to consider the value of some of its alternatives. The most accurate method of cost accounting is the linear regression method, which considers the costs at each activity level to define a mathematical function that best approximates the relationship between costs and activity level. This method is based on all of the data points available, rather than just the highest and lowest activity levels. In this way, it accounts for the possibility that the highest and lowest activity levels are not representative of costs as a whole.