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Under the high-low method, the difference in costs between the high and lowest levels are variable costs.True/False:

Answer:

True

This statement is true, because the both levels have same Fixed cost, therefore, when their total costs are subtracted Fixed Cost is eliminated and only remaining cost is the Variable costs of the differential units or activity between two levels.

What is High-Low Method: Explanation with Example

The high-low method is a cost accounting and managerial economics method of separating fixed and variable components of a mixed cost that has both fixed and variable parts. This method estimates the fixed and variable cost components of a specific expense by examining data from high and low activity levels. This data is useful for budgeting, forecasting, and making decisions.

Here’s an example of how the high-low method works:

Assume a corporation produces widgets and incurs production costs. The cost of production varies according to the quantity of widgets produced in a month. The following is the data over the last six months:

MonthProductionTotal cost
11,000$8,000
21,500$9,500
32,000$10,800
42,500$12,500
53,000$14,000
63,500$15,800

To use the high-low method, we need to identify the highest and lowest activity levels and their corresponding costs. In this example:

High Activity Level: 3,500 widgets (Month 6) – Total cost: $15,800

Low Activity Level: 1,000 widgets (Month 1) – Total cost: $8,000

Step 1:

Calculate the variable cost per unit Variable cost per unit = (Total cost at high activity – Total cost at low activity) / (High activity level – Low activity level)

Variable cost per unit = ($15,800 – $8,000) / (3,500 – 1,000) = $7,800 / 2,500 = $3.12

Step 2:

Calculate the fixed cost component

Fixed cost = Total cost at low activity – (Variable cost per unit x Low activity level)

Fixed cost = $8,000 – ($3.12 x 1,000) = $8,000 – $3,120 = $4,880

Step 3:

Formulate the cost equation The cost equation can be written as:

Total Cost = Fixed Cost + (Variable Cost per Unit x Activity Level)

Total Cost = $4,880 + ($3.12 x Activity Level)

Using this equation, a business can now predict its production costs for various levels of widget production. It will help with budgeting and decision-making.

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