METHODS FOR SEPARATING MIXED COST

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Several methods are used for separating mixed costs into fixed and variable. There are four major techniques that are found in practice and they are discussed below.

(a) High and low points method:

This approach considers the difference in total cost between two different volumes, and divides the incremental cost by the volume. As the words 'high' and 'low' imply, the two levels of volume chosen are the highest and the lowest for the periods under review. The result of this division is the estimated variable cost per unit.
Then, the average activity level is computed together with the average cost for the periods in the database. The fixed cost is estimated by taking the total average cost and subtracting the variable cost for the average activity level. The variable cost is computed by multiplying the average activity level by the variable cost per unit as determined above.

(b) Scatter graph method:

Another approach to the estimation of the fixed and variable components of a mixed cost is the scatter-graph method. With this procedure, various costs are plotted on a vertical line, the y-axis, and measurement figures (activity levels such as direct labor hours, units of output, percentage of capacity, or direct labor cost) are plotted along a horizontal line, the x-axis.

A straight line is fitted to this scatter of points by visual approximation. The slope of the line is used to estimate the variable costs and the intercept of the line with the vertical axis is considered the estimated fixed cost.

(c) Least squares regression method:

The method of least squares uses the equation for a straight line: Y = a + bx, with an as the fixed element, and b as the degree of variability. For many accounting applications, regression provides an accurate estimate of fixed and variable costs.
The answer under regression differs from the scatter-graph method because observation does not offer as accurate an answer as this mathematical procedure. Individuals cannot differ in their separation of fixed and variable components. However, this method has drawbacks; it fits a straight line to any set of cost data no matter how erratic the cost behavior pattern may be. Further, unless a computer is available for this work, the calculations required by the method of least squares are laborious and time-consuming.

(d) Accounting or analytical approach:

This approach to cost behavior analysis is close scrutiny of the chart of accounts and classification of costs into their fixed and variable components according to their basic characteristics determined by the accountant using good judgment, knowledge, and experience. This approach is simple and inexpensive but in its simplicity lies its inherent weakness.

The results obtained are not accurate and may happen to be mere guesses. To improve this method, costs over a period of time can be watched. The time selected must be long enough to provide valuable data over a wide range of activities. Having collected cost data at different production levels, the accountant then proceeds to identify fixed and variable costs. Costs that appear to be semi-variable must be set aside for further analysis into fixed and variable components.

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