Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Break-Even Price

What it is:

The break-even price is when the money received from the sale of a product covers the expenses associated with producing that product.

How it works (Example):

The basic idea behind a break-even price is to calculate the point at which revenues begin to exceed costs. To do this, one must first separate a company's costs into those that are variable and those that are fixed. Fixed costs do not change with the quantity of output. They do not change with the amount of output, and they are not zero when production is zero. Examples of fixed cost include rent, insurance premiums or loan payments. Variable costs change with the quantity of output. They are zero when production is zero. Examples of common variable costs include labor directly involved in a company's manufacturing process and raw materials.

For example, at XYZ Restaurant, which sells only pepperoni pizza, the variable expenses per pizza might be:

Flour: $0.50
Yeast: $0.05
Water: $0.01
Cheese: $3.00
Pepperoni: $2.00
Total: $5.56

Its fixed expenses per month might be:
Labor: $1,500
Rent: $3,000
Insurance: $200
Advertising: $500
Utilities: $450
Total: $5,650

Based on the total variable expenses per pizza, we now know that XYZ Restaurant must price its pizzas at $5.56 or higher just to cover those costs. But if the price of a pizza is $10, then the contribution margin, or the revenue minus the variable cost for XYZ Restaurant is ($10 - $5.56 = $4.44).

But how many pizzas does XYZ Restaurant need to sell at $10 each to cover all those fixed monthly expenses? Well, if $4.44 is left over from each pizza after accounting for variable costs, then we can determine that XYZ Restaurant must sell at least ($5,650 / $4.44 = 1,272.5) pizzas per month in order to cover monthly fixed costs.

It is important to note that some fixed costs increase "stepwise," meaning that after a certain level of revenue is reached, the fixed cost changes. For example, if XYZ Restaurant began selling 5,000 pizzas per month rather than just 2,000, it might need to hire a second manager, thus increasing labor costs.

Why it Matters:

Calculating a break-even price can be tricky, but it helps business owners determine when they'll begin to turn a profit and it helps them price their products with that in mind. It provides a dynamic overview of the relationships among revenues, costs and profits.

However, typical variable and fixed costs differ widely among industries. This is why comparison of break-even prices is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" break-even price should be made within this context.

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