 Hello, and welcome to the session. This is Professor Farhad. In this session, we would look at the high-low method, one of the three methods for cost estimation. In the previous recording, we looked at the engineering estimates and accounting analysis. This topic is covered in cost accounting, managerial accounting, as well as the CPA exam, DBEC section. As always, I'm gonna remind you to connect with me on LinkedIn. Subscribe to my YouTube. I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you want additional resources to supplement this course or other accounting and finance courses, please check out my website, farhadlectures.com. So what is the high-low method, and what is it used for? Well, it's basically a simple approach to understand the relationship between the activity and the cost, and it's gonna help us separate our costs into variable component and fixed component, because that's very important for managers and for cost accounting, because once you know how the cost behave, then you can make a better decision, because remember, fixed cost is fixed within a relevant range. So if we understand this information, we can make a better decision. And remember, variable cost varies in total, but per unit it's the same. So it's very important to understand if you have an overhead cost, can you figure out which part of it is variable, which part of it is fixed? Well, we have overhead cost here. We have labor hours, and we have material cost. The cost is mixed, the overhead cost is mixed. It has a fixed component and a variable component. How can we find out which one is the fixed component, which one is the variable component? Well, we have to assume there's some sort of a linear relationship between cost and activity. What is the activity here? The activity is labor hours. So simply put, the more labor hours we do, the more overhead cost or the less overhead cost, we don't know. So we have to find out what is the relationship, and based on the relationship, hopefully we can draw a straight line. And once we draw a straight line, there's a linear relationship and it's a straight line, we can find the slope of the line. And the slope of the line, it's gonna give us the various, I'm sorry, the variable component. Once we know the variable component, once we know this component, then the remaining is the fixed cost. So simply put, once we find the slope, the slope of the line is rise over run, and from a mathematical or algebra equation, y2 minus y1 divided by x2 minus x1. Simply put, from our perspective, we're gonna take the change in cost divided by the change in activity. Now, which cost and which activity are we going to use to find this? We're gonna choose the high and the low method. So what do you have to do, the high activity and the low activity? But how do you start this estimate? Well, you start this estimate by looking at the graph, drawing a scatter graph real quick to find out if there is a relationship between the activity and the dollar amount. Here, we're gonna be assuming, we're assuming the following, that there is a relationship between labor hours and overhead cost. Simply put, we are saying labor hours is driving overhead cost. So this is labor hours, and this is the cost. Now, we are going to basically graph those figures. And if it look, if there is a line, and we draw a line in the middle, if the points are around the line, then we could assume there's some type of a relationship. If the points are scattered away from the line, then there's no relationship. So the closer they are to the line, the better off they are. So what they did is they draw this line for us and this is what it looks like. This is what it looks like. So this is the labor hours, the activity on the x-axis, which is the predictable value. And the dollar amount, the dollar amount, the dependent value. So what we find out, it seems there is a linear relationship between labor hours and overhead cost. Otherwise, if there was no relationship, that the points will be something like this. They'll be all over the place and there is no relationship. Now, there is a relationship. What we need to do now is to find the slope of the line. How do we find the slope of the line? Well, we're gonna look at the change in activity at the highest level and the lowest level in the change in cost. So to find the slope of the line, we're gonna look at the cost at the highest activity and the cost of the lower activity. Find the difference, find the change and divide the change by the highest level of activity by the highest and the difference between the highest and the lowest. Let's take a look at this. So the intercept is estimated by taking the total cost at either activity and subtracting the estimated variable cost. So what is the intercept? The intercept is this point here. Let me put it in red. The intercept is the fixed cost. Now, it looks like the fixed cost is someplace around $20,000 when we draw this line. You have to draw the line in the middle. Now, you don't have to do this. Excel will do it for you if you have Excel. But the point is if you can find out the variable cost per unit, then if you have total cost and variable cost, take out the variable cost from the total cost, you will find the fixed cost. So the fixed cost will be the total cost at the highest level of activity minus the variable cost times the highest level of activity, which is the variable cost, total variable cost. Or we can take the fixed cost, which is the total cost minus the variable cost at the lowest level of activity. So let's apply this method using this data. First, we have to find the highest level of activity. The highest level of activity happens in month seven. And we see that the activity is in month seven, 1,136 hours. And the overhead cost is $55,581. The lowest level of activity is $400. And at month five and the overhead cost is $35,621. So let's find the slope of the line. Well, we look at the change in the dollar amount, the difference in the dollar amount divided by the change of activity. And we find out that the variable cost per unit is $27.13. This is the variable cost. This is also the slope, the slope of the line. Now what we have is let's use this information to find the fixed cost at the seventh month. The fixed cost equal to the total cost, $55,581 minus the variable component. What's the variable component? The variable component is $27.16 times the activity, which will give us a fixed cost of 24,000, 24,761, 24,761. So an estimate for the cost at any activity level can be computed by total cost, by total cost equal to fixed cost plus variable cost. Okay, that's that hopefully this make sense. So the total cost, if you want to estimate total cost at 960 labor hours, we would say we have a fixed component of 24,761 plus $27.13 times the activity, 916. And we estimate that total cost should be $50,806 if we produce or if we use, if we consume 960 hours of labor hours. Now is this method 100% accurate? And the answer is no, why not? Because you use two line. So to show you that it's not accurate, let me take the ninth month. The nine month had 896 labor hours. If we use this formula to figure out what should be our total cost, well, we said fixed cost is 24,761, that's the fixed cost equal to the fixed cost plus the variable component. The variable component is, what's the variable component, $27.13 times 896. So let's see if it's gonna give us 44,844. So let's do this. So first we'll multiply. All right, there you go. We're gonna take $27.13 times 896. That's the variable component, $24,308.48. Now I'm gonna add to this the fixed cost that I find out from my formula from the high-low method formula, plus $24,761, and that's gonna give me $49,069. So $49,069. So this is my prediction based on this formula. If I look at my actual cost, my overhead cost, it's $44,844. And also this formula, you have to remember it's based on the total cost, y equal a plus bx. Remember this formula, y equal to total cost. This is the total cost equal to a, which is the fixed cost plus b of x. x is the independent variable, which is the variable cost. x is the labor hours, and b is the variable cost. This b is the slope of the line. So notice it's not 100% accurate. So what do we have to do then? Well, we could use what's called the regression analysis to find out the variable cost and the fixed cost. It's gonna give us a better figure. The reason why it's not accurate, because you're only choosing two figures. It's close enough, but nowadays with the regression, you can do regression on Excel, so it's easier and it's more accurate to do regression to find out your A, your intercept, and your variable cost and your slope. In the next session, we would look at the regression. As always, I'm gonna remind you to check out my website, farhatlectures.com for additional resources for this course, as well as other accounting and finance courses. Good luck, study hard, and of course, stay safe.