Why a manufacturing firm may prefer to use the linear regression model over the high-low method in estimating total costs?

The High-low method is a cost accounting term that helps to separate the fixed and variable cost in case the company lacks enough data. The method considers the highest and lowest level of activity and then compares the costs at the two levels. We can say that from all costing data – including labor hours, machine hours, costs, and more – this method considers only the highest and the lowest data as inputs.

This method helps determine the variable and fixed cost if the variable cost is fixed per unit and fixed cost is the same for all volume levels. In this method, we use the equations and formula to get the fixed and variable costs. We can use this method anywhere we want to split the fixed and variable cost, be it the total cost for a company, production cost, process cost, project cost, payroll cost, and more.

Though this method is easy to use, it is not very popular. It could give inaccurate results due to the dependence on two extreme values (the high and low).

Why a manufacturing firm may prefer to use the linear regression model over the high-low method in estimating total costs?

High-low Method Accounting – Formula

The high-low method is a two-step process. Here, the first step is to come up with an estimate of variable cost per unit. The next step is to use step one to determine the fixed cost for a certain level of production. If you have results from the two stages, then it gets easy to calculate an approximate cost for a level of production.

Once we separate the variable cost (b) and fixed cost (a), we use a linear cost volume function to calculate the total cost. This function is – y = a + bx. Here y is the total cost, and x is the production level.

Now, let’s see the formula for the high low method. In this, first, we calculate the variable cost per unit (b).

Formula for this is: 
`(y_2 − y_1)/(x_2 − x_1)` OR

(Highest Production Level of Cost-Lowest Production Level of Cost) / (Highest Production level Units – Lowest Production level Units)

Here `y_2` is the total cost at maximum production, and `y_1` is the total cost at minimum production,

`x_2` is the number of units at maximum production, and `x_1` is the number of units at minimum production.

By solving this equation, we will get the variable cost per unit. This slope is nothing but the change in cost due to the change in production.

Now to determine the total fixed cost, we need to deduct the total variable cost determined as per the above equation from the total cost of production. We can do this either at the maximum or minimum production. The answer will be the same in both cases because the fixed cost remains the same irrespective of the output.

So, the formula for Fixed Cost is `y_2 − bx_2` or `y_1 − bx_1`

Advantages of High Low Method

Using the high low method offers the following benefits:

Easy to use : The high-low method only requires the cost and unit information at the highest and lowest activity level to get the required information. Managers can implement this technique with ease since it does not require any special tools.

High accuracy with stable costs : The high low method can be relatively accurate if the highest and lowest activity levels are representative of the overall cost behavior of the company. However, if the two extreme activity levels are systematically different, then the high low method will produce inaccurate results.


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