## Pricing using Break-even Point

2.   BREAK-EVEN PRICING

The second pricing approach is known as Break-even Pricing. Like Markup Pricing, Break-even pricing uses business costs as its main variable in determining product prices. The major difference between the two methods, however, is that Break-even Pricing considers both product costs and operating expenses, whereas markup pricing uses only your cost to manufacture or purchase direct materials (product costs). Moreover, Break-even Pricing attempts to calculate the price which must be charged in order to "cover" all forecasted product costs and operating costs. When the break-even price is determined, business owners simply increase it to reflect a desired year end profit.

To illustrate how break-even pricing works, lets assume the ABC Company sells one model of televisions. Each television is purchased from the supplier for \$200. It is estimated to cost \$50 to ship each television from the supplier's location to the ABC Company's place of business. After conducting market research, the ABC company feels it will sell 400 televisions in the upcoming year. In addition, the company forecasts its marketing expenses for the upcoming year at \$15,000, while administrative costs are anticipated to be \$70,000. Income taxes will not be considered in this example. Lets organize the above information into a chart format.

 Product Costs: Total Cost to buy each television (\$200 + \$50 shipping) \$ 250 Forecasted number of T.V. to be sold during the year 400 Total product costs \$100,000 Operating Expenses: Forecasted Marketing Expenses \$ 15,000 Forecasted Administrative Expenses \$ 70,000 Total Forecasted Operating Expenses \$ 85,000 Total Forecasted Product Costs & Operating Costs \$185,000

What price must the ABC Company charge for each television in order to cover its product costs and operating expenses for the upcoming year (IE to break-even)? The process is simple. If you know your forecasted product costs and operating costs (\$185,000) and estimate the number of products you plan to sell over the year (400 tv's), then you can determine the price you must charge customers for each television.

Here's the formula:

Total Product Costs and Operating Costs           =              \$185,000
The Number of Products You Plan to Sell                         400 televisions

=              \$ 462.50

Therefore, the ABC Company must charge \$ 462.50 for each television in order to Break-even (IE to cover all of its forecasted product costs and operating costs for the upcoming year).

What price would the company have to charge if it wanted to make a profit of \$15,000 for the year? The formula remains the same, however, the desired profit must be added to the forecasted product costs and operating costs.

Total Product Costs + Operating Costs + Desired Profit            =
The Number of Products You Plan to Sell during the year

\$185,000 + \$15,000
400 televisions

=     \$ 500

Therefore, the ABC company would have to charge customers \$500 for each television set in order to cover its anticipated product costs, operating expenses, and to achieve a desired profit of \$15,000 for the upcoming year.

Lets look at another example depicting how manufacturers might use the break-even pricing approach to set their prices. Lets first look at the assumptions required for our illustration.

Required Assumptions:

• Suppose you plan to establish a manufacturing company that assembles picture frames.
• The only direct material needed in assembling each picture frame is four precut pieces of wood.  Assume the four precut pieces of wood costs \$1.00, while the shipping costs are estimated at .50 cents.
• Each frame takes, on average, 30 minutes to assemble.
• You have hired an employee who you will pay \$3.00 for each frame he assembles. (we will not consider employer costs in this example).
• You anticipate to sell 2,500 frames over the upcoming year and decide to have an inventory level of 500 finished picture frames at the end of the business year. Thus, you are required to assemble 3,000 frames during the year.
• All inventory will be considered finished and assembled. Moreover, the the 500 ending inventory of frames will be assemble into a finished product and ready for resale.
• After a thorough investigation, you estimate operating expenses (administration and marketing expenses) for the upcoming year will be \$24,000.
• You desire a profit of \$20,000 for the upcoming year.

 SUMMARY OF ASSUMPTIONS: Time to assemble each picture frame 30 minutes per frame Direct labor cost per frame \$3.00 per frame Number of frames to assemble 3,000 frames Forecasted unit sales during the year 2,500 frames Desired finished inventory at end of year 500 finished frames Direct material costs per frame \$1.50 each frame Forecasted Operating Costs for upcoming year \$24,000 Desired profit for the year \$20,000

STEPS TO DETERMINE YOUR PRICE USING THE BREAK-EVEN APPROACH

STEP 1 - DETERMINE YOUR DIRECT LABOR COSTS FOR THE YEAR
Since you will pay a direct laborer \$3.00 for each frame he assembles, your total direct labor cost will be \$9,000. That is; 3,000 frames are to be produced over the year at a direct labor cost of \$3.00 each (3,000 frames x \$3.00 labor per frame = \$9,000).

STEP 2 - DETERMINE YOUR DIRECT MATERIAL COSTS FOR THE YEAR
Each frame will be purchased from your supplier at a cost of \$1.00 plus \$0.50 shipping and handling. Therefore, your cost for each frame is \$1.50 (\$1.00 + \$0.50). If you plan to assemble 3,000 frames, your total direct material cost for the year will be \$4,500 (3,000 frames x \$1.50 per frame).

STEP 3 - DETERMINE YOUR TOTAL PRODUCT COST FOR THE YEAR
To determine your total product cost, simply add the annual forecasted direct labor cost to the annual forecasted direct material costs. In our example, the forecasted direct labor cost is \$9,000, while the forecasted direct material cost is \$4,500 (taken from step one and step two above). Therefore, the total product cost for the upcoming year is estimated at \$13,500 (\$4,500 + \$9,000).

STEP 4 - DETERMINE YOUR ANNUAL OPERATING EXPENSES
Operating Expenses consist of marketing and administrative expenses. The forecasted annual marketing and administrative expenses for the upcoming year is estimated at \$24,000 (taken from the required assumption's section).

STEP 5 - MAKE A CHART OF ALL YOUR COSTS FOR THE YEAR
This step involves making a chart of your Total Product Costs (direct labor cost & direct material cost), and your anticipated Operating Expenses (marketing and administrative expenses). As illustrated in the chart below, the forecasted expenses for the upcoming year amount to \$37,500.

 Forecasted Total Product Costs (step 3) \$13,500 Forecasted Operating Expenses (step 4) \$24,000 Total Forecasted Annual Expenses \$37,500

STEP 6 - DETERMINE YOUR BREAK-EVEN PRICE
This step involves dividing the number of forecasted UNIT SALES (picture frames) for the upcoming year by the TOTAL FORECASTED ANNUAL EXPENSES. Recall from our assumptions, you planned to sell 2,500 frames over the year. Also, in step 5 you determined your total forecasted annual expenses to be \$37,500. Therefore, our formula would look like this;

Total forecasted annual expenses      =            \$37,500
Number of frames you plan to sell                2,500 frames

=         \$15.00 per frame

Therefore, in order to cover all the business expenses, you would have to sell each frame for \$15.00 (\$37,500 / 2500 frames). In other words, if you were to sell 2500 frames at \$15.00 each, you would generate sales of \$37,500. If you generate sales of \$37,500 and your yearly expenses total \$37,500, then your profit is Zero (\$37,500 - \$37,500).

STEP 7 - ALLOW FOR A DESIRED PROFIT FOR THE YEAR
If you sell the frames for \$15.00 each, you will break-even, which means you will achieve a profit of Zero (\$0.00). What if you wanted to make a year end profit of \$20,000? In other words, what price must you charge for each picture frame in order to achieve a Net Income before income taxes of \$20,000? To allow for your desired annual profit, simply add the desired profit to your total expected business costs and divide by the number of units you anticipate to sell.

 Forecasted Product Costs (step 3) \$13,500 Forecasted Operating Expenses (step 4) \$24,000 Desired Profit for the year (step 7) \$20,000 Total Expenses & Desired Profit \$57,500

Your total expenses and desired profit margin amount to \$57,500. Now you divide by the number of frames you anticipate to sell. The resulting figure gives you the price at which each picture frame must be sold for in order to achieve a profit of \$20,000.

Total Expenses & Desired profit for the year     =         \$57,500
Number of picture frames you plan to sell                2500 frames

=      \$23.00 per frame

Therefore, you would have to sell each frame for \$23.00 in order to cover all your forecasted expenses and to achieve a profit of \$20,000.

Once you have determined the costs involved in producing the product, it becomes simple to determine the price you must to charge to cover anticipated costs and reach desired profit levels. Keep in mind, however, wholesalers and retailers will markup the products in which they purchase from the manufacturer so that they will make their own profit. If these margins become too high, end consumers may not purchase, which certainly has a direct effect on your sales.

Categories: Marketing