Question

1. Sam manufacturing Co. Ltd estimates their manufacturing overheads based on direct material quantity. The company presented the following data for the past 6 months:

Direct material quantity (kg)	Actual Overhead costs (£)
80,000	860,000
85,000	905,000
96,000	1,020,000
100,000	1,050,000
75,000	815,000
60,000	650,000

Requirements:

1. Using the necessary data above, determine the variable and fixed overhead costs using any management accounting technique. You should also discuss the strengths and limitations of your chosen technique (in reference to the data presented above and the outcome of the computation).                   

Answer 1

Solution:

The management accounting technique used for determining variable and fixed overhead costs is high-low method.

Using High-low method,

i.) The variable cost per unit = (highest activity cost - Lowest activity cost) / (highest Activity units - Lowest activity units)

= ($10,50,000 – $650,000) / (100,000 – 60,000

= $400,000 / 40,000

Variable overhead cost = $10 per direct material

ii.) Fixed cost

For the calculation of fixed costs we are using the activity level of 60,000 direct materials.

Fixed costs = Total cost - (Direct material × Variable cost per unit)

= $650,000 - (60,000 × $10)

= $50,000

.

Advantages and disadvantages of high-low method

Strength:

A major advantage of the high-low method of cost estimation is its simplicity. The separation between variable and fixed cost will not require any complex data or calculation. We only need the total production and total mixed cost. The estimates using this method will be extremely accurate If costs are relatively stable over time and are perfectly linear.

weakness:

The main weakness of this method is that high-low method is that it will produce inaccurate results if the costs are relatively unstable. This is because the high-low method only uses two points to calculate a cost estimate. Another weakness is that Inflation is wholly ignored in the high low method. The variable and fixed cost will not be the same if we consider inflation. In this scenario the cost are not relatively stable, this will leads to small variations in the estimate calculated using high-low method.

Example:

In this scenario the actual cost incurred for 85,000 direct material is $905,000. But as per the estimates using high-low method the total cost at this activity level will be $900,000 ([85,000 × $10] + $50,000). Here we can see a variation of $5,000 when calculated using high low method.