# Using Break-Even Analysis And Demand Analysis For Pricing

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Using Break-Even Analysis And Demand Analysis For
Pricing
than practical. Chief among these    production. Total variable costs
Pricing decisions are one of       tools is demand curves and           (TVC) vary, however, in direct
the most important aspects         break-even analysis. Demand          proportion to production. These
of the process of developing       curves indicate the quantity of a    relationships can be symbolically
a successful marketing mix.        good that would be demanded at       expressed as follows.
Unfortunately, many have a         different prices. Break-even
difficult time understanding       analysis provides the number of      Total Fixed Cost = f (Time) (1)
and using analytical tools for     units that must be sold at a         Fixed Cost Per Unit = FC[sub u] =
pricing decisions. This article    certain price to cover fixed and     f (Quantity) = TFC + Q (2)
by Jon Hawes and Michael           variable costs. Unfortunately, it    Total Variable Cost = TVC = f
D. Amico from the Journal          is often difficult to show the       (Quantity) = VC[sub u]u (Q) (3)
of Education for Business          usefulness of these two              Variable Cost per Unit = VC[sub
says that two classical tools,     important concepts.                  u] (4)
break-even analysis and                                                 Selling Price per Unit = P[sub u]
demand analysis are                                                     (5)
simultaneously very
Basic Concepts Of Break-
helpful for price decision         Even Analysis
A basic assumption in break-         Some costs (TFC) are incurred
making. EM                                                              regardless of the firm's level of
even analysis is that all relevant
costs can be categorized as either   output and are a function of the
.
fixed or variable. Fixed costs are   time frame under consideration.
There are a number of reasons
those that do not vary in total in   Some costs (TVC) vary in direct
why pricing and price
relation to changes in quantity of   proportion to the firm's level of
competition have been rated the
output. Though total fixed costs     output. This leads directly to the
Number 1 problem facing
(TFC) remain constant over the       break-even formula:
marketing executives. First,
relevant range of output, the                       TFC
price plays both an allocation
fixed cost per unit (FCu) would              BE = ---------
and information role in a
vary, of course, depending upon                     P-VC
purchase decision. The
allocation role aids in assigning   the level, or quantity, of output
under consideration.                 This may be effectively translated
limited resources to gain the
into words as follows: How many
greatest degree of value from
Variable costs per unit (VC[sub      profit per unit gains (P[sub u] –
purchased products. Price also
u]), however, are costs that can     VC[sub u]) are required to cover
provides customers with product
reasonably and accurately be         the Fixed costs (TFC) that are a
information, particularly
allocated to particular units of     function of time?
regarding product quality.
output. Variable costs per unit
A number of simple tools are        are assumed to remain constant       Static And Dynamic Break-
used to help pricing managers       over the relevant range of           Even Analysis
make pricing decisions. But they                                         A single calculation of the break-
often appear more theoretical

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even point in units (or in dollars)    As the selling price per unit          price of the good and the quantity
that is based on a set of costs        approaches the variable cost per       that would be demanded or sold
and a single selling price is called   unit, the required volume level        at each price, holding all other
static break-even analysis. This       must increase to reach the             things constant.
calculation is useful information      break-even point. So long as the
for understanding how much             selling price per unit exceeds the     Although a number of firms
sales is required to avoid losing      variable cost per unit, there          currently use both break-even
money. Unfortunately, though an        exists a theoretical break-even        and demand analysis to aid in
assumed selling price was a            quantity. In reality, however, the     pricing decisions, rarely are
required element in the                required volume becomes so large       the two used simultaneously.
determination of the break-even        that it loses practical significance   The simultaneous presentation
point, there is little insight in      when the selling price per unit        use of both concepts provides a
break-even analysis on whether         approaches the variable cost per       much better idea of not only the
that price is achievable in the        unit.                                  price that should be
market place.                                                                 charged to break even, but also
As the selling price increases, the    the price that buyers are willing
Dynamic break-even analysis,           volume required to reach the           to pay for the product. The profits
on the other hand, is iterative.       break-even point decreases. At         with each price can therefore also
A series of break-even points are      extremely high levels, the break-      be shown within a realistic range.
calculated for a series of             even quantity becomes extremely        The juxtaposition of a price
respective prices. By comparing        low. At infinitely high selling        demand curve with iso-
the change in break-even points        price, the break-even quantity         profit curves permits the
with the change in price, the          would decrease without bound.          identification of profitable
pricing analyst is better able to      In practice, however, some             prices, points of maximum
understand the relationships.          reasonable range of prices and         profitability, break-even
quantities must be established.        points.
Relating Break-Even                    Combining an iso-profit curve
with other analytical tools            The advantage of the two
Analysis To The Pricing                helps determine a realistic            methods is that it focuses on the
Decision                               range of prices and quantities.        price within a range that
Dynamic break-even analysis            Demand analysis and break-even         customers are willing to pay.
provides relevance to product          analysis are complimentary tools.      Many managers often become
pricing decisions. You can show                                               preoccupied with using break-
graphically all the possible                                                  even analysis as a justification
Demand Analysis
combinations of selling prices                                                for reducing break-even
The range of product prices
and respective break-even                                                     operating levels. Though this is
worthy of consideration can be
quantities. A plot of the                                                     certainly a worthy goal, it is
determined by considering the
combinations of selling price and                                             important that these decisions
relevant demand curve for that
quantity that create equal profit                                             not be made in a vacuum.
product. A demand curve shows
(in this special case, zero profit)
the relationship between the
is called an "iso-profit curve."

Sincerely,

Eric G. Mitchell
Publisher –