This tool is employed to separate fixed and variable costs from a mixed cost pool. It operates by analyzing the highest and lowest activity levels and their associated costs. The difference in costs between these two points is divided by the difference in activity levels to determine the variable cost per unit. Subsequently, the fixed cost component is derived by subtracting the total variable cost at either the high or low activity level from the total cost at that same level. For example, if the highest production month saw 10,000 units produced at a cost of $50,000 and the lowest saw 2,000 units produced at $20,000, the variable cost per unit would be calculated as ($50,000 – $20,000) / (10,000 – 2,000) = $3.75.
Understanding the fixed and variable components of costs is critical for budgeting, cost control, and pricing decisions. It allows businesses to better predict costs at different production volumes and to assess the profitability of different products or services. Although a simplified approach, this method provides a readily accessible means of cost estimation, particularly useful when detailed cost data is unavailable or costly to obtain. Its origins lie in basic cost accounting principles and it continues to be a valuable technique for preliminary cost analysis.
