DATE: December 15, 2008
TO: Accounting Manager
FROM: Scott Hebert
SUBJECT: Predicting Mixed Costs
While studying fixed costs, it has become apparent that some costs do not fit neatly into one of the two standard cost categories: fixed or variable. For example, the company’s telephone bill has a standard monthly charge, and then an additional charge based on the number of minutes used. The standard monthly cost is an example of a fixed cost because it does not change based on usage. The additional per minute fee, on the other hand, is a variable cost that directly reflects the number of minutes used. Together these costs form a third category called mixed costs. Mixed costs are calculated by adding fixed costs and the total variable cost (“What are mixed costs?”, 2006).
In order to predict mixed cost behavior, mixed costs must be divided into their constituent fixed and variable cost components using one of two popular methods, the High-Low or Least Squares methods. The High-Low method uses the outlying data points to determine the fixed and variable costs. Because these data points lie at the extreme of each measurement, their data is more closely tied to the variable units than other data points dispersed closer to the median. The method is computed by taking the difference in mixed costs for the two extreme data points and dividing by the difference in variable units. The result is the variable cost and can be subtracted from the total mixed cost to generate the fixed cost (Siegel & Shim, 2006).
Unlike the High-Low Method, the Least Squares Method takes all data points into account and tries to find the mix of fixed and variable costs that best fits. The Least Squares Method uses differential calculus to define the line of best fit for all data points. The use of calculus means this method is too complicated for simple estimations, but it is much more accurate than the High-Low Method which can be fooled by outliers that do not match the dispersion of the main data points (Siegel & Shim, 2006).
Siegel, J. G., & Shim, J. K. (2006). Accounting handbook. 4th ed. New York: Barron’s.
What are mixed costs? (2006). Accounting coach Q&A. Retrieved December 15, 2008.