Absorption pricing, Overview, Explanation

Absorption Pricing

What is Absorption Pricing?

Absorption pricing is a way of setting a price so that it covers both variable costs and fixed costs related to that product. This is also known as full-cost pricing. Absorption pricing ensures that most of the costs are included with the product price and a true view of the profit margin can be seen.


How to Calculate Absorption Pricing?

Absorption pricing can be done by taking Variable costs and adding the total Administrative and Overhead Expenses (Which are the element of fixed cost) with it and dividing the result by the Number of units produced.


Example of Absorption Pricing

Company A produced 20000 units of products. The variable cost was $5 per unit. The overhead expense was $500,000, and the administrative expenses were $300,000.

So the absorbed price would be: Variable cost per unit + ((Total overhead + administrative expenses) ÷ Number of units produced)

$5.00 Variable cost + (($500,000 Overhead + $300,000 Administration) ÷ 20,000 units)
=  $40.00/unit

Advantages of Absorption Pricing

#1. Easily calculated: Absorbtion price doesn't require any specialist to calculate price as this uses a simple formula.
#2. If you know the fix and variable costs, you'll earn profit.

Disadvantages of Absorption Pricing

#1. The Absorption Pricing method doesn't consider what is going on in the market. It doesn't care about the competitor's prices.

#2. In the end Absorption Pricing could lead us to aggressive prices.

#3. There is always a possibility that you made mistake in calculating variable and fixed costs as these all are budgeted. If you made any mistake in the calculation all pricing strategies may fall.

Summary:

The absorption Pricing model can't be used in market price setting as this model doesn't think about the competitor's price. Absorption Pricing can be used to compare the market price to absorption-based prices, to see if a company's costs are good enough to get a profit.
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