Basic Marketing: A Global Managerial Approach

Perreault−McCarthy: Basic
Marketing: A
Global−Managerial
Approach, 14/e

18. Price Setting in the
    Business World

Text © The McGraw−Hill

Companies, 2002

Price Setting in the Business World 525

Some price setters use break-even analysis in their pricing. Break-even analysis

evaluates whether the firm will be able to break even—that is, cover all its costs—

with a particular price. This is important because a firm must cover all costs in the

long run or there is not much point being in business. This method focuses on the

break-even point (BEP)—the quantity where the firm’s total cost will just equal its

total revenue.

To help understand how break-even analysis works, look at Exhibit 18-8, an

example of the typical break-even chart. The chart is based on a particular selling

price—in this case $1.20 a unit. The chart has lines that show total costs (total

variable plus total fixed costs) and total revenues at different levels of production.

The break-even point on the chart is at 75,000 units—where the total cost and

total revenue lines intersect. At that production level, total cost and total revenue

are the same—$90,000.

The difference between the total revenue and total cost at a given quantity is the

profit—or loss! The chart shows that below the break-even point, total cost is higher

than total revenue and the firm incurs a loss. The firm would make a profit above the

break-even point. However, the firm would only reach the break-even point, or get

beyond it into the profit area, ifit could sell at least 75,000 units at the $1.20 price.

Break-even analysis can be very helpful if used properly, so let’s look at this

approach more closely.

A break-even chart is an easy-to-understand visual aid, but it’s also useful to be

able to compute the break-even point.

The BEP, in units, can be found by dividing total fixed costs (TFC) by the fixed-

cost (FC) contribution per unit—the assumed selling price per unit minus the

variable cost per unit. This can be stated as a simple formula:

BEP (in units)
 Total fixed cost

Fixed cost contribution per unit

This formula makes sense when we think about it. To break even, we must cover

total fixed costs. Therefore, we must figure the contribution each unit will make to

covering the total fixed costs (after paying for the variable costs to produce the

Break-Even Analysis Can Evaluate Possible Prices

Break-even charts help

find the BEP

How to compute a

break-even point

Total revenue and cost ($000)

75

Total revenue curve

Break-even point

Total cost curve

Total variable costs

Total fixed costs

Loss area

Profit area

0

10 20 30 40 50 60 70 80 90100

10

20

30

40

50

60

70

80

100

90

Units of production (000)

Exhibit 18-8

Break-Even Chart for a

Particular Situation