Assuming that the scattergraph plot indicates a linear relation between cost and activity, the fixed and variable cost elements of a mixed cost can be estimated using the high-low method or the least-squares regression method. The high-low method is based on the rise-over-run formula for the slope of a straight line. As previously discussed, if the relation between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per unit of activity. Consequently, the following formula can be used to estimate the variable cost:
To analyze mixed costs with the high-low method , begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period with the lowest activity is selected as the first point in the above formula and the period with the highest activity is selected as the second point. Consequently, the formula becomes:
Therefore, when the high-low method is used, the variable cost is estimated by dividing the difference in cost between the high and low levels of activity by the change in activity between those two points.
To return to the Brentline Hospital example, using the high-low method, we first identify the periods with the highest and lowest activity—in this case, June and March. We then use the activity and cost data from these two periods to estimate the variable cost component as follows:
Having determined that the variable maintenance cost is 80 cents per patient-day, we can now determine the amount of fixed cost. This is done by taking the total cost at either the high or the low activity level and deducting the variable cost element. In the computation below, total cost at the high activity level is used in computing the fixed cost element:
Both the variable and fixed cost elements have now been isolated. The cost of maintenance can be expressed as $3,400 per month plus 80 cents per patient-day or as:
The data used in this illustration are shown graphically in Exhibit 2–10 . Notice that a straight line has been drawn through the points corresponding to the low and high levels of activity. In essence, that is what the high-low method does—it draws a straight line through those two points.
EXHIBIT 2–10 High-Low Method of Cost Analysis
Sometimes the high and low levels of activity don’t coincide with the high and low amounts of cost. For example, the period that has the highest level of activity may not have the highest amount of cost. Nevertheless, the costs at the highest and lowest levels of activity are always used to analyze a mixed cost under the high-low method. The reason is that the analyst would like to use data that reflect the greatest possible variation in activity.
The high-low method is very simple to apply, but it suffers from a major (and sometimes critical) defect—it utilizes only two data points. Generally, two data points are not enough to produce accurate results. Additionally, the periods with the highest and lowest activity tend to be unusual. A cost formula that is estimated solely using data from these unusual periods may misrepresent the true cost behavior during normal periods. Such a distortion is evident in Exhibit 2–10 . The straight line should probably be shifted down somewhat so that it is closer to more of the data points. For these reasons, least-squares regression will generally be more accurate than the high-low method.
The Least-Squares Regression Method
The least-squares regression method , unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components. A regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. The basic idea underlying the least-squares regression method is illustrated in Exhibit 2–11 using hypothetical data points. Notice from the exhibit that the deviations from the plotted points to the regression line are measured vertically on the graph. These vertical deviations are called the regression errors. There is nothing mysterious about the least-squares regression method. It simply computes the regression line that minimizes the sum of these squared errors. The formulas that accomplish this are fairly complex and involve numerous calculations, but the principle is simple.