When I ask new entrepreneurs what pricing model they use for their products, most often look at me in bewilderment. Model, you say? Some tell me that the price is simply what they “feel” is right, others may say that it’s the price of a comparable product in the market, and the bolder ones tell me that they want to undercut their competition so their price is simply X percentage less than the leading competitor’s.
Although none of these methods are inherently wrong, I always suggest a business to evaluate their pricing decisions with a break-even analysis. A break-even analysis is simply used to find your break-even point (BEP). At what dollar amount of revenue and units sold will the cost and expenses associated with the production of the product be fully covered. There’s no profit or loss at this point. Everything is simply equal to each other. Why is this important? Because this is the point at which your price should not fall below (assuming demand remains the same). If you price too aggressively and it’s below the BEP, you will incur a loss on every single product you sell.
1. The first step is to identify all your fixed costs. These are costs that you will incur regardless of whether a sale will occur. For example, rent, insurance, salaries for administrative staff, membership fees, etc.
2. Identify all your variable costs. Variable costs are directly attributable to each product sold. Variable costs go up as sales go up. These include cost of inventory, cost of sales, sales commissions paid, etc.
Now, in more advanced BEP analysis, fixed costs may convert into variable costs. For example, you might need to produce so many products that you now need to acquire additional space. Variable costs can convert into fixed costs. You might have negotiated a deal with the electric company that caps the bill at a certain amount. And demand will fluctuate with the price changes. For the purposes of this illustration, we’re going to keep it simple and not assume any of these intricacies.
3. Let’s say for example, total fixed cost = $1,000, the variable cost per each unit sold is $5.00 and the sales price for each unit is $15. Therefore your break-even point is calculated as:
BEP (in units) = Fixed Cost / (Sales Price per unit – Variable Cost per unit)
BEP (in units) = $1,000 / ($15 – $5)
BEP (in units) = $1,000 / $10
BEP (in units) = 100 units
That means if you choose to sell your product at $15 per item, then you must sell at least 100 pieces in order for you to cover your expenses. At 100 units, your revenue equals $1,500 ($15 x 100 units) and your expense also equals $1,500 ($1,000 fixed cost + $500 variable cost). If you priced your product under $15, then you will incur a loss on the 100 units.
For argument’s sake, you wanted to desperately undercut your competitor at $10 a unit. You will only generate revenues of $1,000 ($10 x 100 units), but your total expenses equal $1,500. You will have a loss of $500.
Let’s say you saw this and decided to increase your price to $25. Your BEP will then be 50 units ($1,000/$20). This means you only need to sell 50 units to cover all your costs. For every unit above 50 that you sell, you are making a profit. If you sell 100 units in total, your profit is $1,000 ($25 – $5 variable cost x 100 units).