Absorption Pricing: Everything You Need to Know
Absorption pricing allows manufacturers to bear some or all of the freight costs required to ship goods to a customer.3 min read
2. Disadvantages of Absorption Pricing
3. How to Formulate Absorption Pricing
Absorption pricing allows manufacturers to bear some or all of the freight costs required to ship goods to a customer. With absorption pricing, all the costs of transport are recovered. That means an item will come with a variable cost, including the proportionate amount of fixed costs.
This method of pricing ensures all costs are recovered by sharing fixed costs between products. Fixed costs are absorbed into the price of the goods because each price point includes the variable cost plus a percentage of the fixed costs.
Absorption pricing is a variation on full cost pricing because the full cost is charged to a product. However, the profits aren't factored into the price tag. The term "absorbed" insinuates all costs have been absorbed by the final price.
Why Do Businesses Use Absorption Pricing?
Absorption pricing is used to calculate the long-term price of a product that is required to pay for all expenses. Businesses use this method to ensure long-term profitability.
Some businesses use a variation of absorption pricing, known as freight absorption pricing. This allows the seller to include the cost of the freight in the price point.
Here are some added benefits of absorption pricing:
- It's easy to formulate. You can derive a product's price point using absorption pricing because it is based on a straightforward formula that doesn't need to be calculated by someone with specialized training.
- You're likely to make a profit. As long as your budget is accurate and your profit margin is added, your company is likely to make a profit.
Disadvantages of Absorption Pricing
Here are some of the disadvantages of absorption pricing:
- It ignores the competition. If you set a price based on absorption pricing alone, you may be surprised if you see the competition is charging something drastically different.
- Absorption pricing ignores elasticity. You risk pricing items too high or too low, based on what buyers are willing to pay. That could mean you're either giving away profits or not seeing enough revenue.
- It leaves room for error. The formula for your prices is based on budget estimates. If you've calculated your costs or sales volume wrong, you could create a margin of error.
Absorption pricing is not a good way to derive the price for a product that's going to be sold in a competitive market. It does not account for competitor pricing or the value of the product to your customers.
A better approach would be to price your items at market value, allowing the entire line of products with varying profit margins to absorb the company's expenses.
Don't be afraid to explore this approach and compare it to market pricing. It doesn't hurt to know if your company could turn a profit with this methodology.
How to Formulate Absorption Pricing
To calculate absorption pricing, divide your overhead and administrative costs by the number of goods produced. Then, add that result to the variable cost per unit. Here's the formula:
- Variable cost per unit + (overhead + administrative costs) / number of goods produced
Note: Your formula should include any additional markups.
Here's an example: Company XYZ thinks it will incur $500,000 in overhead and $250,000 in administration costs. It expects to sell 20,000 units. Each unit has a variable cost of $10.00. This makes the fully absorbed price:
$10.00 + ($500,000+$250,000) / 20,000 = $47.50/unit.
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