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What is Absorption Pricing?
Absorption pricing is the pricing strategy also known as full costing. It entails capturing variable cost and fixed costs associated with manufacturing a particular cost per unit of a product. As many other strategies, absorption pricing is directed toward determining the most cost to ensure a good profit margin.
When it comes to fixed costs along with a variable cost, it often includes the cost of materials, labor, rent, and insurance. Putting together these costs allows establishing a proper price to ensure adequate profit margin. In terms of absorption pricing, inclusion of variable cost along with fixed costs is paramount.
How to Calculate Absorption Pricing?
To calculate absorption pricing, a company needs to know variable cost along with fixed costs. Absorption pricing formula relies on several key steps:
- Calculate your cost price. To calculate the cost price, a company needs to start with the Cost of Goods Sold (COGS) and overhead costs. Narrowing it down, the first step relies upon handling costs, cost of the product acquisition, cost of raw materials, labor, and equipment. Overhead costs in absorption pricing include rent, utility, insurance, and software.
- The second step is to add the cost price to the profit margin . While knowing the cost price and variable cost, a company needs to have an anticipated profit margin. A business sets a reasonable cost per unit or price based on these two factors.
The steps mentioned above represent the foundation of absorption pricing calculation. It is worth noting that the calculation might differ for companies producing the product and firms reselling the product.
Advantages of Absorption Pricing
There are several advantages to Absorption Pricing. These include the following:
- The method is simple to use. Determining the product's final price does not require extensive training or some specific knowledge.
- When knowing fixed and variable costs, profit is almost guaranteed with absorption pricing. As long as you do the calculation right, you will know the profit to anticipate.
- Absorption pricing is easy to formulate. Whether wholesale order management or freight absorption pricing is determined, the overall approach relies on only several factors.
The advantages of absorption pricing grant a clear vision of profit margin and cost per product unit.
Disadvantages of Absorption Pricing
Like with any given pricing strategy, there are certain disadvantages of absorption pricing:
- The method does not consider the competition. The strategy avoids the pricing strategies of competitors, which can be problematic.
- The approach ignores the aspect of value. In the end, absorption pricing can lead to aggressive prices. As a result, your clients will look for alternatives.
- The strategy has room for error. The formula for absorption pricing includes variable and fixed costs, which stem from budget estimates. If you calculate costs incorrectly, there will be a margin of error in the entire pricing strategy.
Disadvantages of absorption pricing make companies aware that the strategy is not a one-fits-all solution. While the approach is easy to apply, some key moments are still to consider.
All in all
Absorption pricing is a simple and effective way to set a reasonable cost of a product based on the anticipated profit margin. Yet, some challenges need to be addressed. When calculating absorption pricing, do not forget to check the competition and double-check the method for errors.
Find answers to some of the most common questions people have regarding the use of Competera.
What is absorption in standard costing?
Absorption is standard costing is the instrument for allocating fixed overhead costs to a product regardless of it being sold in the period.
How do you calculate absorption costing?
Absorption costing is calculated by determining the cost price and adding it to the profit margin.