Managerial Decision Making: Absorption vs. Variable Costing

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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Companies often have many decisions to make regarding setting prices. In this lesson, we look at two ways to set prices, one using absorption costing and the other using variable costing.

Types of Costing

When your company is trying to set the prices of its goods or services, you're likely to take into consideration several different methods to find a final price. Sometimes, you'll just multiply the cost of your expenses by a number. Other times, hopefully more rarely, you'll make up a price that 'sounds about right.'

However, there are two more precise ways of setting prices. In this lesson, we'll look at variable costing and absorption costing. We'll see how each method is used and look at examples where each method is particularly suited for the business being considered.

Variable Costing

Let's start with variable costing. When you use variable costing, you're setting your price based off of the variable cost per unit plus a markup. Remember that the variable cost per unit is the cost it took to create that unit. Contrast this with fixed costs, which are costs that have already been paid to run your business, like rent or equipment. Variable costs increase as you make more of a product, while fixed costs remain constant. The markup should cover a portion of both your fixed costs and the profit you want to make. This is especially suited for times when your variable cost is low and your fixed cost is relatively high.

Let's say that you're the owner of an amusement park. You've got all sorts of fixed costs, from buying the equipment to paying for the land. Relatively speaking, though, your variable cost per unit sold - here a ticket - is relatively low. Sure, you have to make sure you have enough staff, but you can easily absorb more customers. Your usual cost per ticket is \$100, of which \$80 is for markup, and \$20 covers your variable cost. On a day that the park is open, a large group comes up and asks if they can get a special where each of them pays only \$70 per person. You already have plenty of people in the park, but you won't need to hire any more staff for the day, and it won't raise your fixed costs since they are riding the rides you already have. Should you let them in?

If you're using variable costing, absolutely! You're easily meeting your variable cost of \$20 per person. The remaining \$50 goes to markup. Sure, you wouldn't want to sell all of your tickets at \$70 apiece, but if you turn them away, you will be turning away \$50 per person of markup. That could go towards paying your fixed costs or to your profits. After all, the park is already open; they are just taking up spare capacity.

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