The breakeven price is the point of no profit or loss. Similarly, breakeven pricing is the strategy of setting prices at which a business will earn zero profit and no loss too. Or, we can say, the price at which the company earns zero profit or loss. Also, such a strategy allows a firm to set the lowest acceptable price. It is a type of Cost-based Pricing.
Importance of Breakeven Pricing
It is a common strategy that companies use to set the price of their products. Such a pricing strategy helps managers when preparing business and marketing plans and when entering a new market. We can also say that achieving economies of scale is one more objective of breakeven pricing.
Such a pricing strategy helps the company gain market share and push competitors out of the market. Also, it allows the management to make better decisions in the case it wants to boost production or limit the costs. For example, many e-commerce companies use this pricing strategy to gain or grow their market share.
Such a strategy helps a company to gain price-conscious consumers. Also, a company can poach customers of competitors using this strategy. However, implementing such a strategy is not as simple as it sounds. Since adopting this strategy means no profit, the company must have the necessary resources to keep it going.
The necessary resources here primarily mean funds to keep the company going until it starts to make a profit.
Formula for Breakeven Price
To calculate the break-even point (BEP), we need to divide the total fixed cost by the volume and then add Variable Cost per unit to it. For those unaware, fixed costs are the ones that do not change with the change or fluctuations in the level of production. And the company needs to incur them irrespective of the production level. For example, rent, insurance, and more. On the other hand, variable cost varies with the production level, such as raw material.
The formula for BEP is – (Total fixed cost/Production unit volume) + Variable Cost per unit
Let’s understand the calculation with the help of an example. Suppose Company A has fixed costs of making mobile of $50,000 and the variable cost per unit is $10. Company A wants to sell 10,000 units in a year.
BEP in this case will be ($50,000/10,000) + $10 = $15.
So, Company A can set the price above $15 to earn a profit. But, if it sets the price below it, it won’t earn any profit.
A point to note is that the BEP formula includes the number of items that a company expects to sell. In reality, this number could be different from the expectations. So, the real break-even price would be somewhat different from what the formula gives.
Read more about other CVP Analysis tools.
Advantages and Disadvantages of Breakeven Pricing
Following are the advantages of using breakeven pricing:
- It helps the company to reduce the competition and dominate the market.
- Such pricing also acts as an entry barrier to discourage new entrants.
- It also helps a company to achieve economies of scale.
- It is an effective pricing strategy for a new entrant.
Following are the disadvantages of using this pricing strategy:
- Once a company sets a price lower than the competitors to gain market share, it becomes difficult to raise the price later. Customers get used to lower prices, making it harder to raise the price without improving the quality or quantity of the product.
- If a company suddenly decides to drop the price, then it may create a perception problem. Customers might think that the company may have compromised on the quality so as to reduce the prices.
- A decision to follow breakeven pricing may start a price war if competitors also decide to do the same.
- It gets difficult for the company to determine how much price it should raise later so as not to push customers away.
- If the company drops the price and the quality to make up for the loss, then it might lose customers.
- The biggest drawback of this strategy is that it is difficult to sustain. If a company lacks the necessary resources to sustain this strategy, then it could result in heavy losses and even shut down.
- Such a strategy is also against the free market as it reduces competition and acts as an entry barrier.
Also, read the Difference between Breakeven Point vs. Margin of Safety.
Like any other strategy, breakeven pricing is also an effective strategy for market entry, enticing customers of competitors by lower prices and thus creating a good customer base in a short time. However, to implement it successfully, a company must be aware of its fixed and variable costs and have the necessary resources to sustain it. So, we can say that this strategy is not fit for smaller companies with scarce resources.
Learn more about the difference between Accounting Breakeven and Financial Breakeven.