Absorbed: What it Means, How it Works, Examples

What Is Absorbed?

Absorbed as a business term generally refers to the process of taking in, acquiring, or bearing. The term can be applied in a number of different situations, the most common of which is manufacturing overhead. When a company absorbs a cost increase instead of passing it on to a consumer is another instance in which the term can be used. Other instances include absorbing shares in an initial public offering (IPO) and absorbing a firm in a mergers and acquisition transaction (M&A).

Understanding Absorbed

Absorbed is commonly used when discussing a company's overhead costs. Typically, absorbed overhead refers to the manufacturing overhead that has been allocated to produced goods or other cost objects. Cost objects are specific items for which a company wants to quantify costs for managerial accounting purposes. A service, segment, project, activity, and corporate department are all examples of a cost object. Overhead represents indirect costs (i.e., not direct labor or materials) that are assigned to a product or cost object using an overhead rate. When this overhead is allocated, it becomes absorbed.

There are times when overhead is either over- or under-absorbed, meaning that the allocated amount is higher or lower than the actual amount incurred. A firm will eventually correct the imbalance to produce more accurate cost-accounting records.

An absorbed price increase of a cost input refers to the practice of a company choosing to bear the additional cost instead of opting to pass it on to its customers. Choosing to absorb the cost would cut into the company's profit margin, but it is a conscious decision by management to maintain customer satisfaction with respect to price, especially if the product or service in question is subject to a measure of demand elasticity or if there are many competitors in the market. The company would rather keep the sale at a lower margin rather than lose it altogether.

Absorbed Examples

For example, let's say a peanut butter company's cost for peanuts increases from 50 cents per jar to $1.00 per jar. The company decides to keep the cost of one jar at $3 instead of raising it to $3.50, therefore absorbing the increase in peanut price input, rather than passing it on to the customer. However, its profit margin declines.

When an underwriter is unable to sell all the shares of a bought deal in an IPO, it must take in the remaining shares on its own books. The unsold shares are said to be absorbed by the underwriter. A company that has been purchased in an M&A transaction will be absorbed either when the deal officially closes or when its integration with the acquirer is complete.