Perreault−McCarthy: Basic
Marketing: A
Global−Managerial
Approach, 14/e
- Price Setting in the
Business World
Text © The McGraw−Hill
Companies, 2002Price Setting in the Business World 527inventory carrying costs—the break-even point will be lower and profits will start to
build sooner. Similarly, if the variable cost to produce and sell an item can be reduced,
the fixed-cost contribution per unit increases; that too lowers the break-even point
and profit accumulates faster for each product sold beyond the break-even point.Break-even analysis is helpful for evaluating alternatives. It is also popular
because it’s easy to use. Yet break-even analysis is too often misunderstood. Beyond
the BEP, profits seem to be growing continually. And the graph—with its straight-
line total revenue curve—makes it seem that any quantity can be sold at the
assumed price. But this usually isn’t true. It is the same as assuming a perfectly hor-
izontal demand curve at that price. In fact, most managers face down-sloping
demand situations. And their total revenue curves do not keep going up.
The firm and costs we discussed in the average-cost pricing example earlier in
this chapter illustrate this point. You can confirm from Exhibit 18-4 that the total
fixed cost ($30,000) and average variable cost (80 cents) for that firm are the same
ones shown in the break-even chart (Exhibit 18-8). So this break-even chart is the
one we would draw for that firm assuming a price of $1.20 a unit. But the demand
curve for that case showed that the firm could only sell 60,000 units at a price of
$1.20. So that firm would never reach the 75,000 unit break-even point at a $1.20
price. It would only sell 60,000 units, and it would lose $6,000! A firm with a
different demand curve—say, one where the firm could sell 80,000 units at a price
of $1.20—would in fact break even at 75,000 units.
Break-even analysis is a useful tool for analyzing costs and evaluating what might
happen to profits in different market environments. But it is a cost-oriented
approach and suffers the same limitation as other cost-oriented approaches. Specif-
ically, it does not consider the effect of price on the quantity that consumers will
want—that is, the demand curve.
So to really zero in on the most profitable price, marketers are better off
estimating the demand curve itself and then using marginal analysis, which we’ll
discuss next.^6Marginal Analysis Considers Both Costs and Demand
Break-even analysis is
helpful—but not a
pricing solutionThe best pricing tool marketers have for looking at costs and revenue (demand)
at the same time is marginal analysis. Marginal analysisfocuses on the changes in
total revenue and total cost from selling one more unit to find the most profitable
price and quantity. Marginal analysis shows how profit changes at different prices.
Thus, it can help to find the price that maximizes profit. You can also see the effect
of other price levels. Even if you adjust to pursue objectives other than profit
maximization, you know how much profit you’re giving up!To explain how marginal analysis works, we’ll use an example based on a firm
with the specific cost and demand numbers in Exhibit 18-9. This example uses sim-
ple numbers to ensure that the explanations are easy to follow. However, the
approach we cover is the same one that managers use. A manager who works with
large numbers might use spreadsheet software to do the calculations and create a
table like the one shown in Exhibit 18-9. However, as you’ll see in the example,
only basic adding, subtracting, multiplying, and dividing are required.
Our example and discussion focus on a firm that operates in a market where there
is monopolistic competition. As we noted in Chapter 17, in this situation the mar-
keting manager does have a pricing decision to make, and the firm can carve out a
market niche for itself with the price and marketing mix it offers.^7Marginal analysis helps
find the right priceMarginal analysis when
demand curves slope
down