Definition of 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.
The calculation of absorption pricing for an individual unit is to divide total overhead and administrative costs by the number of units produced, and add the result to the variable cost per unit. The formula is:
Variable cost per unit + ((Total overhead + administrative expenses) ÷ Number of units produced)
The formula may also include an additional markup for profit, at the discretion of the company.
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.
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.
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)
Advantages of Absorption Pricing
The following are advantages to using the absorption pricing method:
- Simple. It is quite easy to derive a product price using this method, since it is based on a simple formula that does not have to be calculated by someone with specialized training.
- Likely profit. As long as the budget assumptions used to derive the price turn out to be correct and a profit margin is added, a company will probably earn a profit if it uses this method to calculate prices.
Disadvantages of Absorption Pricing
The following are disadvantages of using the absorption pricing method:
- Ignores competition. 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.
- Ignores price elasticity. 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.
- Budgeting basis. 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.