# Absorption Costing Approach to Pricing:

Learning Objective of the Article:

1. Compute the selling price of a product using the absorption costing approach.
2. What are the advantages or benefits, disadvantages/limitations of absorption costing approach

The absorption costing approach to cost plus pricing differs from the economists’ approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost rather than variable costing.

## Setting a Target Selling Price Using the Absorption Costing Approach:

For example, let us assume that the management of Ritter Company wants to set the selling price of a product that has just undergone some design modification. The accounting department has provided cost estimates for the redesigned product as shown below:

 Per Unit Total Direct materials \$6 Direct labor 4 Variable manufacturing overhead 3 Fixed manufacturing overhead \$70,000 Variable selling, general, and administrative expenses 2 Fixed selling, general and administrative expenses 60,000

The first step in the absorption costing approach to cost plus pricing is to compute the unit product cost. For Ritter Company, this amounts to \$20 per unit at a volume of 10,000 units as calculated below:

 Direct materials \$6 Direct labor 4 Variable manufacturing overhead 3 Fixed manufacturing overhead (\$70,000 / 10,00 units) 7 ——- Unit product cost \$20 ====

Ritter company has a general policy of marking up unit product costs by 50%. A price quotation sheet for the company prepared using the absorption costing approach is presented below:

 Direct materials \$6 Direct labor 4 Variable manufacturing overhead 3 Fixed manufacturing overhead (based on 10,000 units) 7 ——– Unit product cost 20 Markup to cover selling, general, and administrative expenses and desired profit–50% of unit manufacturing cost 10 ——– Target selling price \$30

Note that selling, general and administrative (SG&A) costs are not included in the cost base. Instead, the markup is supposed to cover these expenses. Let us see how some companies compute these markup percentages.

## Determining Markup Percentages:

How did Ritter Company arrive at is markup percentage of 50% in the above schedule? This figure could be a widely used rule of thumb in the industry or just a company tradition that seems to work. The markup percentage may also be the result of an explicit computation. As we have discussed, the markup over cost ideally should be largely determined by market conditions. However a particular approach is to at least start with markup based on cost and desired profit. The reasoning goes like this. The markup must be large enough to cover sales, general and Administrative (SG&A) expenses and provide an adequate return on investment (ROI).

Given the forecasted unit sales, the markup can be calculated by using the following formula:

Markup percentage on absorption cost = [(Required return on investment × Investment) + SG&A expenses] / Units sales × Unit product cost

To show how the formula above is applied, assume Ritter Company must invest \$100,000 to produce and market 10,000 units of the product each year. The \$100,000 investment covers purchase of equipment and funds needed to carry inventories and accounts receivable. If Ritter Company requires a 20% return on investment (ROI), then the markup for the product would be calculated as follows:

Markup percentage on absorption cost = (20% × 100,000) + (\$2 × 10,000 + \$60,000) / 10,000 × \$20

= (\$20,000) + (\$80,000) / \$200,000

50%

This markup of 50% leads to a target selling price of \$30 for Ritter company. As verified by the following calculations:

 Direct materials \$6 Direct labor 4 Variable manufacturing overhead 3 Fixed manufacturing overhead (\$70,000 / 10,000 units) 7 ——- Unit product cost \$20 ====== INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS–RITTER COMPANY ACTUAL UNIT SALES PRICE  = 10,000 UNITS; SELLING PRICE = \$30 Ritter Company Absorption Costing Income Statement Sales (\$30 per unit × 10,000 units) \$300,000 Less cost of goods sold (\$20 per unit × 10,000 units) 200,000 ————– Gross margin 100,000 Less selling, general, and administrative expenses (\$2 per unit  10,000 units + \$60,000) 80,000 ————– Net operating income \$20,000 ======= Return on investment ROI Return on investment (ROI) = Net operating income / Average operating assets = \$20,000 / \$100,000 = 20%

If the company actually sell 10,000 units of the product at this price, the company’s return on investment (ROI) on this product will indeed be 20%. If it turns out that more than 10,000 units are sold at this price, the ROI will be greater than 20%. If less than 10,000 units are sold. the return on investment (ROI) will be less than 20%. The required return on investment (ROI) will be attained only if the forecasted unit sales volume is attained.

## Problems | Disadvantages and Limitations with the Absorption Costing Approach:

Using the absorption costing approach, the pricing problem looks deceptively simple. All you have to do is calculate cost, decide how much profit you want, and then set your price. It appears that you can ignore demand and arrive at a price that will safely yield profit whatever profit you want. However, as noted above, the absorption costing approach relies on a forecast of unit sales. Neither the markup nor the unit product cost can be computed without such a forecast. The absorption costing approach essentially assumes that the consumers need the forecasted sales and will pay whatever price the company decides to charge. However, customers have a choice. If the price is too high, they can buy from a competitor or they may choose not to buy at all. Suppose, for example, that when Ritter Company sets its price at \$30, it sells only 7,000 units rather than the 10,000 units forecasted. As shown in above calculations, the company would then have a loss of \$25,000 on the product instead of a profit of \$20,000. Some managers believe that the absorption costing approach to pricing is safe. This is an illusion. This approach is safe only as long as customers choose to buy at least as many units as managers forecasted they buy.

 Direct materials \$6 Direct labor 4 Variable manufacturing overhead 3 Fixed manufacturing overhead (\$70,000 / 7,000 Units) 10 ——– Unit product cost \$23 ===== INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS–RITTER COMPANY ACTUAL UNIT SALES PRICE  = 7,000 UNITS; SELLING PRICE = \$30 Ritter Company Absorption Costing Income Statement Sales (\$30 per unit × 7,000 units) \$210,000 Less cost of goods sold (\$23 per unit × 7,000 Units) 161,000 ———— Gross margin 49,000 Less selling, general and administrative expenses (\$2 per unit × 7,000 units + \$60,000) 74,000 ———— Net operating income \$(25,000) ======= Return On Investment (ROI) Return on investment (ROI) = Net operating income / Average operating assets = – \$25,000 / \$100,000 =  – 25%

Rather than focusing on costs–which can be dangerous if forecasted unit volume does not materialize–many managers focus on customer value when making pricing decisions.