ABSORPTION PRICING Meaning and
Definition
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Absorption pricing refers to a pricing strategy where a company sets its product prices based on the full absorption of all costs incurred in the production process. This approach aims to recover all direct and indirect costs associated with manufacturing and selling a product, including variable and fixed costs.
Unlike other pricing strategies that focus solely on variable costs or market conditions, absorption pricing takes into account all costs, irrespective of their variability with production volumes. It includes direct materials, direct labor, factory overheads, administrative expenses, and selling costs. By incorporating fixed costs, absorption pricing helps businesses avoid losses in situations where sales volumes are low or fluctuating.
The process of absorption pricing involves determining the total fixed and variable costs per unit of production. These costs are then divided by the expected production output to arrive at the per-unit cost. A predetermined profit margin is added to the per-unit cost to establish the selling price.
Absorption pricing is commonly used by producers of goods, such as manufacturers and wholesalers. It allows them to maintain stable pricing while ensuring that all expenses are covered. However, this strategy can be disadvantageous when demand fluctuates, as it may result in overpricing or underpricing compared to market conditions.
Etymology of ABSORPTION PRICING
The term "absorption pricing" originates from the combination of two separate elements: "absorption" and "pricing".
First, the word "absorption" derives from the Latin word "absorptus", which is the past participle of "absorbere". In Latin, "absorbere" means "to swallow up" or "to take in". The concept of absorption is related to the process of something being soaked up or assimilated, often in the context of business or economics.
Second, the term "pricing" comes from the Old English word "prisan", which means "to fix a price". It pertains to setting or determining the value or cost of a product, service, or commodity.
When combined, the term "absorption pricing" refers to a pricing strategy in which all costs, including fixed and variable expenses, are uniformly allocated to each unit of output.
