Break-even pricing refers to the price that must be charged for a good or service in order for the company producing it to recover all of its costs directly associated with its production and to achieve a desired profit margin. Basically, it’s the point at which the total revenue from selling a product or service equals the total amount of variable costs to produce it.
A business can sell a product or service at any price above break-even and make a profit. If the price is below break-even, however, the company will lose money on each sale—and if it sells too cheaply for too long, it may go out of business.
What Is a Break-Even Price?
Break even pricing is a strategy focused on penetrating the market by keeping the price of the product in such a manner that the company is neither in profit nor in loss. Break even price has one of the simplest pricing formulas. Fixed cost + Variable cost = Total cost / Break even price.
Thus, the key factor to maintain break even price is to determine the exact fixed and variable costs. The application of break even pricing comes when making business and marketing plans as well as when trying to penetrate a new market. Even in the business environment, break even price plays an important role.
Break-Even Price Formula
Break-even price is a concept used to determine the sales volume that would allow a business to cover its costs. When you set your break-even price, you’re trying to figure out how many products or services you’d have to sell in order to make back the money you spent on creating them.
The formula for calculating break-even price is:
Break-even point = fixed costs/unit variable cost
Break-even points can vary by industry and product, but they’re usually calculated based on the fixed costs which are all the expenses you have to pay regardless of how many units you sell—things like rent and insurance. Variable costs are those that vary with each unit sold—things like packaging materials and shipping fees.
Break-Even Price Strategy
Whenever you decide to start your own company based on a business idea, your main goal is going to make it profitable and sustainable. But for every business in the initial stages of the development, it takes time to build profits. In these cases the best option for you is to reach a lower break even point, where you are neither in profit nor in loss. Profit is the most desirable goal but not losing money and to be on zero loss can also be an alternative solution rather than getting negative results on your investments.
The break even price can be described as the amount of money for which a product, service or asset has to be sold in order to cover the amount of money required for either manufacturing or providing it. The reasons behind the break even pricing consist in penetrating new markets with low prices in order to capture the customers of your competitors and gain fast market share. It has the potential of being successful if the company has the necessary resources for increasing its production volumes until it manages to reduce costs and make profit at what had previously been the break even price. Thus, economies of scale is another objective of Break even price.
Although it might sound like an excellent idea, besides its clear advantages, this strategy also implies different drawbacks, which if not controlled properly can become an increased risk for the development of your business. If we were to think about the main advantages, the break even price can act as an entry barrier and as a tool for market domination and competition reduction. Using a break even pricing strategy is equivalent to discouraging new entrants to penetrate the market as the profits would be minimal or non existent.
At the same time, not all existing competitors of the market you chose to enter will have the strength to fight with your lower prices as they cannot raise prices, finally collapsing. Finally the market domination is obtained when you increase production capacities and achieve economies of scale.
Fixed and Variable Costs in Break-Even Pricing Strategy
Businesses must be able to identify their fixed costs and variable costs before they can set a break-even point. Fixed costs are those that do not change over time, no matter how many units are produced or sold. Examples include rent and insurance premiums. Variable costs are those that fluctuate depending on production levels; they tend to be directly related to unit sales volume. These include raw materials, labor costs and advertising expenses.
Once a company has identified its variable and fixed costs, they can use these figures along with their revenue projections to find their break-even point—the price at which they can sell enough units in order to cover both their variable and fixed costs without incurring any losses.
Examples of Break-Even Point
You’ve just started a business selling makeup. You have $300,000 in start-up costs, and you make $250,000 worth of sales per year. Your cost of goods sold is $150,000, so you need to bring in $200,000 in revenue to cover those costs and make a profit.
But what if you want to know how much money you need to charge customers for each product to reach your company’s break even point? You might try calculating how much money it takes to cover all of your fixed expenses—your rent/mortgage payment and other overhead—but this approach would give you an inaccurate answer because it would include the the variable cost associated with each sale.
Instead, try using break-even analysis. Break-even analysis lets you determine exactly how many units must be sold in order for your business to be profitable (i.e., not lose money).
For example: a company that sells widgets has $100,000 in fixed costs per year. Each widget sells for $10 and has a variable cost of $5 per unit. The company’s contribution margin per unit is therefore $5 ($10 minus $5).
To find the break-even sales price, divide $100,000 by $5: 100,000 / 5 = 20,000 units. The company must sell 20,000 widgets every year to break even; any fewer than that and it loses money; any more than that and it makes a profit
Drawbacks of Break Even Prices
But let’s take a look at the drawbacks now. We have been speaking in a previous article about the penetration pricing. Something similar can happen also by using the break even price. Once you present the market with a really low cost compared with your competitors, it is hard to increase prices afterwards. It might be possible by improving the quality of the offered product or service. Once you enter the market with a low price, you might risk losing your customers when raising the prices.
On the other hand for example, if you have been into the market for a period and you are suddenly reducing pricing in order to increase your market share, then a perception problem will appear, as customers might doubt the quality of the provided product, considering that there might be a quality issue because of the lowered prices.
Moreover, a price war can be declared. Some of your competitors might decide to play the same game as you so at the end of the day you will not earn any market share. Lastly, the most dangerous situation can be that you decide the penetrate with break even pricing, but the cost was not calculated properly or you are unable to sustain break even price, in which case you will have to exit with heavy losses.
By knowing the total fixed costs, the volume of the production and the variable costs per unit, the company can calculate the break even price. It should be taken into consideration that the total amount counting as fixed costs will remain constant unlike the variable costs which will differ according to the production. Thus, economies of scale will be the target here as more production units will mean lower fixed cost and controlled variable cost per unit.
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