What is the Break-Even Price?
Simply put, the break-even price, also referred to as the break-even point (BEP), refers to the point at which all costs equal total revenue, implying there is no net profit or loss. Put differently, it is the price (point) where an individual or business has ‘broken even’ regarding a specific financial transaction. Some other definitions of break-even price are:- ‘The break-even price is defined as the level of price or amount that the seller of the business should quote that enables him to recover the costs of the business operations.’ (WallStreetMojo)
- ‘The break-even price is the price necessary to make a normal profit. It is a price which includes all costs, including variable and fixed costs.’ (Economicshelp)
- ‘A break-even price refers to the price at which an investor or trader is neither at a profit nor at a loss … Any amount realised above the break-even price is profit.’ (Cleartax)
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Break-Even Price (Point) Analysis
A break-even price (point) analysis is a powerful financial tool for planning and making important business, investment, and trading decisions. If you are a business owner, trader, or investor, or thinking about such a possibility, you should know how to do a break-even price analysis. Regarding investments, determining a break-even price will enable you to know what you are required to do to regain your initial investment, start to generate a profit. In options trading, break-even analysis is applied to figure out the price in the underlying asset at which traders/investors can decide to exercise or cancel the specific contract without incurring a loss. In trading in stock markets, a break-even price refers to the point at which a trader/investor is neutral to the price, and may decide to sell to recover costs, preventing a loss on the transaction. Concerning business operations, break-even price analysis is an accounting process for determining at what price (point) a product or service of a business will be profitable. In the words of My Accounting Course: ‘Break-even point analysis is a measurement system that calculates the margin of safety by comparing the amount of revenues or units that must be sold to cover fixed and variable costs associated with making the sales. In other words, it is a way to calculate when a project will be profitable by equating its total revenues with its total expenses.’ (Accentuation in quotation by the article writer.) The practice of determining a price (point) at which zero profits will be gained or zero losses will be incurred is called break-even pricing.Strategy of Break-Even Pricing
Break-even pricing is a business strategy that is applied to use low prices as a business or financial tool to increase market share and to get the better of competitors in the market place. In addition, a business may be able to rise its production volumes to such a level that it will lower production costs, allowing the business to generate a profit at what had previously been the break-even point (price). Once a business has driven competitors out of the specific market segment, it can increase its price sufficiently for a specific product or service to make a profit. However, the increased price must not be so high to allow new competitors in the market. Break-even pricing is also useful when dealing with a customer that is requesting the lowest possible price.Formula of the Break-Even Price
The formula to calculate the break-even price (point) looks as follows: Break-even price (point) = (Fixed costs)/Production volume) + Variable costs Where:- Fixed costs, also known as indirect costs or overheads, are costs that do not change - or change only slightly - with an increase or decrease in the number of goods manufactured or services rendered.
- Advertising and marketing
- Utilities
- Property taxes
- Rent
- Mortgage payments
- Insurance premiums
- Interest expenses
- Salaries (A fixed compensation paid to employees regardless the hours worked)
- Depreciation
- Vehicle leases
- Loan repayments
- Production volume refers to the production capacity or the amount of finished goods that a business plans to manufacture.
- Variable costs, also referred to as direct costs or prime costs, are volume-related, fluctuating according to the number of units produced and the nature of the production.
- Commissions on sales
- Operational expenses
- Direct labour - wages of employees who are employed on an hourly basis (Also referred to as piece rate labour)
- Direct materials
Example of the Break-Even Price Formula
Business ABC intends to enter the market for colourful garden umbrellas, also called sunshades. The costs of ABC for a given period include rent (R30 000), accounting fees (R5 000), marketing (R3 000), salaries for employees (R20 000 for administrative personnel, and R150 per unit for labour for manufacturing the umbrellas), and material (R80 per unit). ABC expects to sell 250 of the garden umbrellas during the given period. The break-even price for the umbrellas is calculated as follows: 1. Fixed costs are rent, accounting fees, marketing, and salaries for administrative personnel. Variable costs comprise salaries for employees who manufacture the umbrellas, and material. 2. Production capacity is 250 garden umbrellas. 3. Fixed costs divided by the production capacity: (R30 000 + R5 000 + R3 000 + R20 000)/250 = R58 000/250 = R232 4. The variable costs are R150 per umbrella for labour and R80 per umbrella for material, amounting to R230. 5. Break-even price (point) = R232 + R230 = R462 If ABC sells 250 garden umbrellas in the given period, R462 will be the price at which the business breaks even. If the sales are less than 250, ABC would incur a loss. Conversely, if the business were to sell more than 250 umbrellas, ABC would generate a profit. From a different perspective, the break-even price to manufacture 500 garden umbrellas is R346 ((R58 000/500) + R230). On the other hand, if sales amount to 200 umbrellas, the break-even price would be R520 ((R58 000/200) + R230).Pros of Break-Even Pricing
Break-even pricing has numerous advantages, for example:- It enables business managers and entrepreneurs to choose the best pricing strategy, making wise and informed decisions about the short- and long-term profitability of a product or project.
- A break-even analysis helps to cover variable costs as well as fixed costs, which are frequently ignored. When fixed costs are rising, break-even pricing will indicate how much is required to increase the volume of sales or raise prices to cover the increase in fixed costs.
- A break-even price analysis compels you to list all your financial commitments to determine the break-even price, helping you to avoid unpleasant surprises (losses).
- It enables entrepreneurs to make smarter financial decisions, devoid of emotion and based on facts.
- It is a key financial tool to keep a business running smoothly.
- The break-even analysis allows marketers of a business to plan pricing strategies and marketing campaigns.
- It is a useful tool to mitigate risk by indicating when to avoid a new business project or idea, helping to avoid business failures and limit financial losses. In fact, break-even pricing helps you to be realistic about the potential outcomes of products.
- Pricing at break-even points can be applied to discourage new competitors in the market, as well as driving existent competition out of the market.
Cons of Break-Even Pricing
Disadvantages of break-even pricing include, inter alia:- A business may calculate a break-even price on a certain number of sales, but if demand is less than expected, the break-even price will be too low.
- Competitors may respond with even lower prices, disallowing a business to gain any share in the market.
- Substantially reduced prices may create a perception among customers that a product or service is no longer of the same quality.
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