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When forecasting the total cost at various levels of activity (say production) complications can be encountered when cost behaviour is semi-variable. That is part of the cost is fixed and part of the cost is variable. If this is the case then you cannot simply increased tye total cost by the increase in the level of production. For example if the following data have been extracted from cost records.
Production level Cost
1,000 units £2,500
2,000 units £4,500
What would the level of cost be for 4,000 units. Well it certainly would not be £9,000, i.e. twice the cost of producing 2,000 units.
We can predict the level of cost using the high low method.
If we go back to basics we know that fixed costs do not change due to changes in level of activity and that variable costs will change directly in proportion to changes in level of activity.
As the fixed cost element of total cost at 1,000 is the same as the fixed cost element of total cost at 2,000 units, we assume that the change in total cost between the two levels of activity is entirely due to the variable cost per unit. So the first thing we can do is calculate the change in activity and the change in total cost between the highest and the lowest level of activity.
Production level Cost
High 2,000 units £4,500
Low 1,000 units £2,500
Change 1,000 units £2,000
Therefore we can calculate the variale cost per unit at £2 per unit (£2,000 / 1,000 units)
Using the equation for total cost of y = a + bx we can calculate the fixed cost
y = total cost
a = fixed cost
b = variable cost per unit
x = level of activity
We can select either the highest or the lowest level of activitity values to substitute in the equation. Here I use the high level
y = £4,500
x = 2,000 units
b = £2 per unit (calculated above)
£4,500 = a + (2,000units x £2)
£4,500 = a + £4,000
Making a the subject of the equation we get
a = £4,500 - £4,000
a = £500
Now we can forecast the total cost for 4,000 units of production:
y = a + bx
y = £500 + (4,000 units x £2)
y = £500 + £8,000
y = £8,500
So the forecst cost to produce 4,000 units would be £8,500
N.B. The high low method has limitations and if multiple data are availablke regression analysis is more accurate.
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