Absorption Pricing: Meaning, Formula, Examples & Accounting Use

 

Introduction

Absorption pricing is a fundamental concept in cost accounting and pricing strategy, used by businesses to determine the selling price of goods and services. It is highly relevant for business owners, accountants, financial analysts, and tax consultants who deal with product pricing, cost control, GST compliance, and profit planning. In India, understanding absorption pricing helps in better inventory valuation, tax reporting, and strategic decision-making.

Definition

Absorption Pricing is a pricing method where the selling price of a product is determined by including both the variable costs and the fixed costs incurred in production.

This approach ensures that all costs—both direct and indirect—are fully absorbed into the product price, helping to prevent underpricing.

Detailed Explanation

📌 How Absorption Pricing Works

Under this method, total cost per unit = Direct Materials + Direct Labour + Variable Overheads + Fixed Overheads. Then, a markup is added to ensure a profit margin.

📌 Formula:

Absorption Cost per Unit = (Total Fixed Costs + Total Variable Costs) / Total Units Produced

Selling Price = Absorption Cost per Unit + Mark-up

📌 Types of Costs Considered:

Cost Category	Examples
Direct Costs	Raw materials, labor
Variable Overheads	Power, packing, fuel
Fixed Overheads	Rent, salaries, depreciation

📘 Accounting Illustration

Example:

A company produces 1,000 units of a product. The following costs are incurred:

• Direct Material: ₹50/unit

• Direct Labour: ₹30/unit

• Variable Overheads: ₹20/unit

• Fixed Overheads: ₹1,00,000 (Total)

Step 1: Calculate Total Cost Per Unit

Fixed Overhead per Unit = ₹1,00,000 / 1,000 = ₹100/unit
Absorption Cost = ₹50 + ₹30 + ₹20 + ₹100 = ₹200/unit

Step 2: Add Profit Margin (say 20%)

Selling Price = ₹200 + (20% of ₹200) = ₹240

🧾 Journal Entry (for Accounting):

When goods are produced and recorded using absorption pricing:

Finished Goods Inventory A/c    Dr. ₹200,000  
    To Work in Progress A/c               ₹200,000  

When sold:

Cost of Goods Sold A/c          Dr. ₹200,000  
    To Finished Goods Inventory A/c       ₹200,000  

Accounts Receivable A/c         Dr. ₹240,000  
    To Sales A/c                           ₹240,000  

🏛️ Tax Implications & Legal Relevance (India-Specific)

• Income Tax: Absorption pricing helps in inventory valuation under the Income Tax Act, affecting profit and hence, taxable income.

• GST Compliance: Under GST, cost-based pricing can help calculate the correct taxable value, especially in related party transactions or stock transfers where market value is not readily available.

• Transfer Pricing: In inter-company or cross-border transactions, Indian tax authorities may review cost structures, making proper absorption pricing documentation crucial.

🔍 Real-World Example

Company A manufactures 5,000 pens.

• Direct cost: ₹10/unit

• Variable overhead: ₹5/unit

• Fixed cost: ₹50,000

• Mark-up: 25%

Absorption Cost/unit = ₹10 + ₹5 + ₹10 (₹50,000/5,000) = ₹25

Selling Price = ₹25 + 25% = ₹31.25/unit

❓ FAQs (with Schema Markup for SEO)

Q1. What is the main objective of absorption pricing?
Absorption pricing ensures that all production costs are fully recovered and helps avoid selling at a loss.

Q2. Is absorption pricing mandatory under Indian accounting standards?
Yes, under AS-2 (Valuation of Inventories) and Ind AS-2, inventory must be valued using absorption cost methods.

Q3. How is absorption pricing different from marginal pricing?
Marginal pricing includes only variable costs, whereas absorption pricing includes both fixed and variable costs.

Q4. Is absorption pricing suitable for competitive markets?
Not always. In highly competitive markets, businesses may need to use market-based or marginal pricing strategies.

🔗 Related Terms (with Internal Links)

• Marginal Costing
• Cost Accounting
• Transfer Pricing
• Fixed Overheads
• Variable Costs