Pricing - Absorption cost and full cost pricing
If a firm produces a range of products, one accounting issue is how it deals with its fixed/indirect costs, such as rent and interest. This is a subject dealt with in greater detail in the operations and management pack.
Absorption cost and full cost pricing are methods used to allocate all the indirect/fixed costs when determining the price.
- Full cost pricing is simple, because the same formula is used to allocate all the costs to each of the product. The full-cost pricing formula may, for instance, be based on the area of the factory used to create each product.
For example, if a product takes up 45% of the factory space, then the firm will allocate 45% of all of the indirect costs (rent, security, interest payments and so on) to that product. The price will therefore be made up of the direct costs per unit, 45% of the indirect costs per unit and a profit mark-up.
- Absorption pricing is a more sophisticated variant on this where costs are allocated more precisely. Each indirect cost will be treated separately and allocated accordingly.
Rent may be allocated according to the factory space used (i.e. the product that takes 45% of the factory space will have 45% of the rent apportioned to it), but other indirect costs may be apportioned differently. Interest payments, however, may be allocated according to the amount of investment in each product. For example, a product where there has been significant investment made in its production, may bear a higher apportionment of the indirect costs than a product where little investment has been made. Marketing costs may also be apportioned according to the products where most marketing effort has been directed.
Advantages and disadvantages of absorption/full cost pricing
- It recognises the importance of indirect costs as an element of overall cost
- It allows for more accurate and precise apportionment of costs
- It offers a more flexible pricing approach than other cost-based pricing approaches
- It may appear to offer an accurate approach, but in some instances it can be difficult to calculate an accurate apportionment of costs
- If used in isolation it may focus too much on product and costs and not be sufficiently flexible to take into account changes in demand and customer needs