What Is Absorption Pricing?

If you’re just getting started building your pricing strategy and need an approach that will bring you guaranteed profit, you should consider starting with absorption costing. It is often used by online retailers that need to define an optimal product cost that will recoup all production and distribution expenses. This article explains what absorption pricing is and how to implement it in your business.

Absorption pricing means setting the price of a product so as to recoup production expenses in the long term. This approach is used by businesses to guarantee long-term profitability.

Freight absorption costing is often employed by some companies. This enables the vendor to factor the cost of the shipment into the selling price.

The major benefits of absorption pricing include:

1. It’s easy to implement. This is a convenient method for determining a product's price point because it doesn't require a pro to calculate.
2. You can make a profit. Your business is probably going to turn a profit as long as your budget is well-calculated and your profit margin is included.

Absorption pricing is defined for each separate unit by multiplying the variable cost per unit by the total overhead and administrative expenditures, then dividing the result by the number of units produced. The formula is:

Variable cost per unit + ((Total overhead + administrative expenses) ÷ Number of units produced)

At the company's discretion, the formula may also incorporate an additional markup for profit.

Direct costs and indirect expenses serve as components of absorption costing. Expenses that can be directly assigned to a certain item or service are referred to as direct costs and direct materials. Raw materials, labor, and similar expenditures incurred during the production process are included in these prices.

Expenses that are not linked to a certain good or service are referred to as indirect costs. These overhead costs consist of things like rental payments, utilities, or insurance. Typically, indirect costs are assigned to goods or services based on some metric of activity, like the quantity produced or the quantity of direct labor hours needed to make the item.

Absorption costing considers both types of expenses. This means that in addition to the direct expenses of creating each unit, the price of a product also includes a share of the indirect costs incurred during the production process. The cost of each unit is then calculated by dividing the total manufacturing costs by the quantity of units produced.

Let’s say a company anticipates the following costs to be included in its operations in the upcoming year:

• Total cost of overhead – $200,000
• Administrative costs – $120,000

Only 15,000 units are expected to be sold by the company in the future year. The variable cost per unit is $40.00. Before the profit margin is taken into account, the fully absorbed price of the product is calculated as follows:

$40.00 Variable cost + (($200,000 Overhead + $120,000 Administration) / 15,000 items) = $61.3/unit

There are numerous benefits of absorption pricing:

• Simple implementation. The final cost of the product can be calculated without substantial training or specialized knowledge.
• This strategy ensures a profit when you’re well aware of variable expenses. If the math is done correctly, you will be able to predict the profit.
• Easy calculation of absorption price. The general strategy depends on a limited number of elements.

The benefits of absorption pricing provide a clear understanding of profit margin and cost per unit of the product.

You should consider using this strategy together with other methods because it is not devoid of drawbacks:

• The competition is not taken into account by this method. This approach disregards competitors' pricing strategies, which might put competitiveness at risk.
• No consideration of item value. If you set too high prices, your customers will seek alternatives as a result.
• There is room for error in the plan. Variable and fixed expenses, which come from budget estimates, are part of the absorption price formula. You risk losing profits if you calculate variable costs improperly.

Absorption pricing has drawbacks that show it’s not a magic pill – it isn’t equally suitable for everyone. The method is simple to use, but as you can see, there are still some important circumstances to take into account.

This method is unacceptable for determining the price of a product that will be sold in a market where there is competition because it does not take into account the pricing of competitors’ products or how buyers perceive product value.

A more practical strategy is to price each product at its current market value, allowing the entire assortment of products — each with a different profit margin — to cover all costs incurred by the business. To determine whether a company's cost structure will allow it to earn a profit, it may be simpler just to utilize this method to compare absorption-based costs to market prices.

When calculating product cost, absorption pricing takes into account such variable costs as direct materials, raw materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Variable pricing does not consider fixed overhead costs that are assigned to every product manufactured in a specific period.

Absorption pricing is a great method for defining a reasonable price point based on the expected profit margin. However, it comes with a few drawbacks, for example, ignorance of competitors’ actions. The calculated price should be double-checked to avoid errors that come with this approach.

You can enhance the benefits of your strategy by introducing Priceva’s repricing tool: the software will perform deep price analysis, calculate optimal prices, and update them automatically. You’ll be able to react to market changes proactively and stay ahead of the competition or create your own pricing strategy including absorption costing and based on overhead costs.

The absorbed-cost technique accounts for and combines (in other words, absorbs) all direct (or direct materials) and indirect costs and expenses associated with producing a unit of a good.

Whether a product was sold during the period or not, fixed overhead expenses are assigned to it using absorption costing. With this technique of costing, more cost is added to the final inventory, which is carried over to the following period and shown as an asset on the balance sheet.

Absorption costing calculated using the following absorption pricing formula:

Absorption costing = (Direct labor expenses + Direct material expenses + Variable manufacturing overhead expenses + Fixed manufacturing overhead) / Number of units made