Reading: Break-Even Pricing
Introduction
Regardless of the pricing strategy a company ultimately selects, it is important to do a break-even analysis beforehand. Marketers need to understand break-even analysis because it helps them choose the best pricing strategy and make smart decisions about the short- and long-term profitability of the product.
The break-even price is the price that will produce enough revenue to cover all costs at a given level of production. At the break-even point, there is neither profit nor loss. A company may choose to price its product below the break-even point, but we’ll discuss the different pricing strategies that might favor this option later in the module.
Understanding Breakeven
Let’s begin with a very simple calculation of breakeven and build from there.
Imagine that you decide to hold a bake sale and sell cookies in the student union as a social event for students. You don’t want to lose money on the cookies, but you are not trying to make a profit or even cover your time. You spend a very convenient $24 on groceries and bake 4 dozen cookies (48 cookies). What is your break-even price for the cookies? It’s the total cost divided by the number of cookies that you expect to sell, represented by the formula below:
Break-Even Price = Costs / Units
So, it would be $24 / 48 = $.50, or 50 cents per cookie. What if you sell only 40 cookies? The calculation would be $24 / 40 = $.60. Your break-even price goes up if you sell fewer cookies.
One challenge of calculating breakeven is that all of the variables can change, and some are unknown. For instance, it may be impossible to know exactly the quantity that you will sell. For that reason, companies often calculate the break-even quantity rather than the break-even price. Focusing on quantity enables the marketer to answer the following question: “Given this set of costs and this price, how many products must I sell to break even?” The break-even quantity is shown by the following formula:
Break-Even Quantity (in terms of units) = Costs / Price
In our cookie example, once you have spent $24 on groceries, you know your cost. What if you plan to sell the cookies for $1 apiece? According to the equation above, units = cost / price, so in our case, units = $24 / $1, or 24 cookies.
Of course this is a very simple example, but it gives you a sense of why breakeven matters, and how you would calculate it.
Including Fixed and Variable Costs
Let’s add one more complication to make our example a little more realistic and interesting. Your cookies have been such a hit that you decide to sell them more broadly. In fact, you rent commercial kitchen space and hire an experienced baker named Helen to do the baking. Your break-even point just went up dramatically. Now you need to cover the costs of your kitchen and an employee. For the sake of this exercise, let’s assume that Helen works a set number of hours every week—20 hours—and that you pay her $20 per hour including all taxes and benefits. You rent the kitchen for $100 per week, and that price includes all the equipment and utilities. Those are costs that are not going to change no matter how many cookies you sell. If you baked nothing, you would still need to pay $100 per week in rent and $400 per week in wages. Those are your fixed costs. Fixed costs do not change as the level of production goes up or down. Your fixed costs are $500 per week.
Now you need to buy ingredients for the cookies. Once you add up the food costs of making a single large batch of cookies, you find that it’s a total of $7.20 for a batch of 12 dozen (144) cookies. If you divide that out, you can tell that each cookie costs $.05 in food costs ($7.20 / 144 cookies = $.05). In other words, every cookie you sell is going to have a variable cost of $.05. Variable costs do change as production is increased or decreased.
Adding these different types of costs makes the break-even equation more complicated, as shown below:
pn = Vn + FC
p = price
n = number of units sold
V = variable cost per unit
FC = fixed costs
With this equation we can calculate either the break-even price or the break-even quantity.
Calculating Break-Even Price
Chances are good that you can only bake a certain number of cookies each week—let’s say it’s 2,500 cookies—so, based on that information, you can calculate the break-even price. The formula to do that is the following:
p = (Vn + FC) / n
n = 2,500
V = $.05
FC = $500
Therefore, p = (($.05 x 2,500) + $500) / 2,500
p = ($125 + $500) / 2,500
p = $.25
Your break-even price for your cookies is 25 cents. That doesn’t mean it’s the right market price for the cookies; nor does it mean that you can definitely sell 2,500 cookies at whatever price you choose. It simply gives you good information about the price and quantity at which you will cover all your costs.
Calculating Break-Even Quantity
Now let’s assume that you have set your price and you need to know your break-even quantity. You are an exceptional marketing student, so you have talked to the people who are likely buyers for your cookies, and you understand what price is a bargain and what price is too expensive. You have compared the price with competitor prices. And, you have considered the price of your cookie compared to the price of doughnuts and ice cream (both are “substitutes” for your product). All of this analysis has led you to set a price of $2 per cookie, but you want to make sure that you don’t lose money on your business: You need to calculate the break-even quantity. The formula to do that is the following:
n = FC /( p – V)
Using the same inputs for the variables, your equation looks like this: n = $500 / ($2 – $.05)
n = $500 / $1.95
n = 256.41 cookies
So, let’s round-up and just call the break-even quantity 257 cookies. Does that mean that you keep the full $2 as profit for every cookie after 257? Sadly, no. First, you have to cover the variable cost for each cookie ($.05 per cookie), which means you make just $1.95 per cookie you sell (after you’ve surpassed the break-even point). Second, our simple break-even example did not include all of the costs. After you’ve locked down the product costs and the pricing, you will need to invest in promotion and distribution of the cookies. You’ll also probably want to cover your time (i.e., pay yourself) and add some profit into the total fixed costs. For instance, if you wanted to earn a profit of $600 each week, then you would need to add that to the $500 fixed costs of the kitchen and Helen.
Breakeven in the Marketing Strategy
Now that we have a cost example, it’s a little easier to think about the pricing objectives. If you decided to price your cookies with a profit orientation, then you would simply add a profit ($1 per cookie, say,) to the break-even price. That approach doesn’t take the customer into account at all, though, since a profit orientation is only about the business.
What if you found that your campus stores and vending machines sell a national chain of cookies for 75 cents? Using a competitor-oriented pricing approach, you might decide to match that price and compete on that basis. The drawback is that this approach does not take into account the value your customers find in a fresh, local product—i.e., your cookies—made from high-quality ingredients.
A customer-oriented pricing approach allows you to treat the break-even data as one input to your pricing, but it goes beyond that to bring your customers’ perceptions and the full value of your product into the pricing evaluation.