Absorption pricing definition
/What is Absorption Pricing?
Absorption pricing is a method for setting prices, under which the price of a product includes all of the variable costs attributable to it, as well as a proportion of all fixed costs. This is a variation on the full cost plus pricing concept, in that the full cost is charged to a product, but profit is not necessarily factored into the price (though it is likely to be). The term includes the word "absorbed," because all costs are absorbed into the determination of the final price.
Absorption pricing is used to derive the long-term price of a product that is needed in order to pay for all expenses, thereby assuring a business of maintaining profitability over the long-term.
Freight Absorption Pricing
A variation on the concept of absorption pricing is called freight absorption pricing, under which the seller of goods includes the cost of the freight to the buyer in its calculation of the price of the product. This is a more comprehensive approach to pricing than the basic absorption pricing model, and so will result in somewhat higher prices.
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How to Calculate Absorption Pricing
The calculation of absorption pricing for an individual unit is to divide total overhead costs and administrative costs by the number of units produced, and add the result to the variable cost per unit. The formula is as follows:
Variable cost per unit + ((Total overhead + administrative expenses) ÷ Number of units produced)
= Absorption-based price per unit
The formula may also include an additional markup for profit, at the discretion of the company.
Example of Absorption Pricing
ABC International expects to incur the following costs in its business in the upcoming year:
Total overhead expenses = $500,000
Total administration expenses = $250,000
The company only expects to sell its purple widget in the upcoming year, and expects to sell 20,000 units. Each unit has a variable cost of $10.00. The calculation of the fully-absorbed price of the purple widget before the inclusion of a profit margin is:
$10.00 Variable cost + (($500,000 Overhead + $250,000 Administration) ÷ 20,000 units)
= $47.50/unit
Advantages of Absorption Pricing
There are several advantages to using the absorption pricing method, which are as follows:
Complete cost recovery. It ensures that both fixed and variable costs are covered in the product price, thereby minimizing the risk of losses. This approach is particularly beneficial for businesses with high fixed costs, as it allocates these costs to each unit sold.
Profit stability. By including a profit margin in their pricing, businesses can maintain stable profitability as long as sales meet expected volumes.
Simplicity. The method is straightforward and easy to implement. Businesses calculate total costs, add a profit margin, and set the price accordingly.
Sustainable over the long term. This approach helps ensure that prices cover the entire cost of running a business, making the pricing model sustainable over time.
Applicable in low-competition markets. In markets with limited competition or where customers prioritize quality over price, absorption pricing can be effectively used without losing customers.
Reduces the risk of underpricing. By considering all costs, the strategy reduces the chances of setting prices too low, which might lead to losses or unsustainable operations.
Provides a baseline for discounting. This approach provides a clear understanding of minimum pricing thresholds, making it easier to evaluate the impact of discounts or promotions.
Disadvantages of Absorption Pricing
There are also several disadvantages of using the absorption pricing method. First, a company may set a product price based on the absorption pricing formula and then be surprised when it finds that competitors are charging substantially different prices. Second, the company may be pricing too high or too low in comparison to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues. And finally, the pricing formula is based on budget estimates of costs and sales volume, both of which may be incorrect.
Evaluation of Absorption Pricing
This method is not acceptable for deriving the price of a product that is to be sold in a competitive market, because it does not account for the pricing of competitors, nor does it factor in the value of the product to customers. A more realistic approach is to price each product at the market price, so that the entire group of products, with varying profit margins, can absorb all expenses incurred by the company. It may be best simply to use this approach to compare absorption-based prices to market prices, to see if a company's cost structure will allow it to turn a profit.