Definition of Break Even Pricing
Break even pricing is the practice of setting a price point at which a business will earn zero profits on a sale. The intention is to use low prices as a tool to gain market share and drive competitors from the marketplace. By doing so, a company may be able to increase its production volumes to such an extent that it can reduce costs and then earn a profit at what had previously been the break even price. Alternatively, once it has driven out competitors, the company can raise its prices sufficiently to earn a profit, but not so high that the increased price is tempting for new market entrants.
The concept is also useful for establishing the lowest acceptable price, below which the seller will begin to lose money on a sale. This information is useful when responding to a customer that is demanding the lowest possible price.
You can calculate the break even price based on the following formula:
(Total fixed cost / Production unit volume) + Variable cost per unit
This calculation allows you to calculate the price at which the business will earn exactly zero profit, assuming that a certain number of units are sold. In practice, the actual number of units sold will vary from expectations, so the true break even price may prove to be somewhat different.
It is especially common for a new entrant into a market to engage in break even pricing, in order to obtain market share. It is particularly likely when the new entrant has a product that it cannot differentiate from the competition in a meaningful way, and so differentiates on price.
A business intent on following the break even pricing strategy should have substantial financial resources, since it may incur significant losses during the early stages of this strategy.
The Break Even Pricing Calculation
ABC International wants to enter the market for yellow one-sided widgets. The fixed cost of manufacturing these widgets is $50,000, and the variable cost per unit is $5.00. ABC expects to sell 10,000 of the widgets. Therefore, the break even price of the yellow one-sided widgets is:
($50,000 fixed costs / 10,000 units) + $5.00 variable cost
= $10.00 break even price
Assuming that ABC actually sells 10,000 units in the period, $10.00 will be the price at which ABC breaks even. Alternatively, if ABC were to sell fewer units, it would incur a loss, because the price point does not cover fixed costs. Or, if ABC were to sell more units, it would earn a profit, because the price point covers more than the fixed costs.
Advantages of Break Even Pricing
The following are advantages of using the break even pricing method:
- Entry barrier. If a company continues with its break even pricing strategy, possible new entrants to the market will be deterred by the low prices.
- Reduces competition. Financially weaker competitors will be driven out of market.
- Market dominance. It is possible to achieve a dominant market position with this strategy, if you can use it to increase production volumes and thereby reduce costs and earn a profit.
Disadvantages of Break Even Pricing
The following are disadvantages of using the break even pricing method:
- Customer loss. If a company only engages in break even pricing without also improving its product quality or customer service, it may find that customers leave if/when it raises prices.
- Perceived value. If a company reduces prices substantially, it creates a perception among customers that the product or service is no longer as valuable, which may interfere with any later actions to increase prices.
- Price war. Competitors may respond with even lower prices, so that the company does not gain any market share.
Evaluation of Break Even Pricing
This method is most useful for those companies with sufficient resources to lower prices and fight off attempts by competitors to undercut them. It is a difficult approach for a smaller, resource-poor company that cannot survive for long with zero margins.