12.2. Cost-Based Pricing

Cost-based pricing methods involve setting price with reference to costs. For this purpose, it is important for a business to understand how costs may change with the level of output and over time, especially if the business is considering expanding production.

The total cost of production is calculated as follows:

Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)

The total cost of production is the cost of producing any given level of output. As output rises, total cost will increase because of variable costs.

What is a break-even analysis?

A business will often want to know how much they will have to produce and sell of a good or service at a chosen price before they make a profit. Classifying costs as fixed or variable allows managers to undertake this calculation, and to decide on appropriate selling prices for their products.

The break-even level of output is where total sales revenue is exactly equal to total costs. At this point, the firm makes neither a profit nor a loss. That is, the break-even point occurs where:

Total Revenue = Fixed Costs + Variable Costs = Total Costs

Break-even analysis seeks to predict the level of sales a business will need to achieve in order to break even, and to determine how changes in output, costs, and/or price will affect the break-even point and their possible profits.

Calculating break-even point

A firm can calculate its break-even point if it knows its costs and the price it can charge for each unit of output. Consider the following example.

Geoffs Knitwear Ltd has fixed costs each year of £200,000 and variable costs of £5 per jumper produced. The jumpers are sold for £30 each. The break-even level of output for Geoffs Knitwear can be calculated as follows:

Total Cost (TC) = Fixed Costs + Variable Costs

TC = 200,000 + (5 x Q)

and:

Total Revenue (TR) = Price x Quantity Sold

TR = 30 x Q

where Q is the quantity of jumpers produced and sold.

At break-even output, total cost equals total revenue. That is:

TC = TR

200,000 + (5 x Q) = 30 x Q

Thus, to solve the equation by finding Q:

200,000 = 25 x Q

Q = 200,000 / 25 = 8,000

That is, Geoff's Knitwear must produce and sell 8,000 jumpers at a price of 30 pounds each to break even. If more than 8,000 jumpers are sold, the firm makes a profit, while if less than 8,000 are made, the firm makes a loss.

We can check this calculation by returning to the formula TC = TR

200,000 + (5 x 8,000 jumpers) = 30 x 8,000 jumpers

200,000 + 40,000 = 240,000

240,000 costs = 240,000 revenues

We can, therefore, be confident that 8,000 jumpers is the break even level of output in Geoff's Knitwear Ltd.

Break-even charts

The break-even point can also be found by plotting total costs and total revenues on a break-even chart.

The first step is to calculate total costs and total revenues for a number of different levels of output. (As an absolute minimum, two levels of output should be chosen – zero and one other.) In a break-even chart, output or sales are measured on the horizontal (x) axis, while costs are measured on the vertical (y) axis. Break-even output is found at the point at which the total revenue line crosses the total cost line. The area between the two lines represents a loss when TC is greater than TR, and a profit when TC is less than TR.

‘What if’ analysis

Break-even chart is a useful business-planning tool because it allows managers to project what might happen to the break-even output and profits if costs alter, or if the price of the product is changed. For example, if prices are cut, the break-even level of output will rise, since more units will need to be sold to cover production costs.

The margin of safety

Once a business has forecast the level of sales it must achieve at a given price in order to break even, it must then attempt to exceed this level in order to make a profit. In the example above, Geoff’s Knitwear might plan to sell 10,000 jumpers next year – 2,000 more than required to breakeven.

The firm would then be operating above break-even output and will therefore be in the area of profit. This difference between forecast sales and break-even output is known as the margin of safety. In other words, Geoff’s Knitwear has incorporated a margin of safely of 2,000 units into its sales forecast. Sales of jumpers can therefore fall short of the forecast by up to 2,000 (or 20%) before the firm will start to make losses.

Cost-based pricing methods

If a firm is to survive in the long run, it must be able to cover its costs of production. If revenues do not exceed costs, it will make a loss. It may be able to sustain a loss for a while, but in order to continue operating, it must generate enough revenue to cover wage bills and pay for materials and power, rent and rates, and other overheads.

Cost-plus pricing. This involves calculating the cost of producing each unit of output, and then adding a mark-up for profit. For example, if a firm produced 10,000 units of a product costing £20,000, the average cost would be £2. A 10% profit mark-up would mean that units would be priced for sale at £2.20 each.

Contribution pricing. It is relatively easy to calculate the variable costs of producing each unit of output. However, it is often difficult to calculate what proportion of fixed costs such as rent and rates, heating, night-time security, etc., to apportion to each product. Contribution pricing, therefore, involves setting a price for each unit that covers its variable cost and makes a contribution towards total fixed costs, as well as a mark-up for profit. The contribution per unit of output can be calculated as follows:

Contribution per Unit = Selling Price – Variable Cost

The selling price of each unit of output will be chosen so that the total contribution covers fixed costs and yields an acceptable profit, where:

Profit = Total Contribution – Total Fixed Costs

Contribution pricing can also be used to find the level of output at which a firm will break even. For example, returning to the case of Geoff’s Knitwear Ltd, we can calculate the contribution each jumper makes towards fixed costs as follows:

Contribution per Jumper Sold = 30 – 5 = 25

At the break-even output of 8,000 jumpers, the total contribution will be £200,000 (i.e. £8,000 x 25) – exactly equal to total fixed costs. Profit is zero. However, the 8,001st jumper sold will yield a profit of 25 and so on.

The break-even level of output can therefore be calculated using the following formula:

Fixed Cost 200,000

Break-even Output = ——————— = ———— = 8,000

Contribution 25

Contribution pricing methods can be a very useful means of assessing the performance of a business, allowing management to measure and compare the contribution made by all of the various products the firm produces. Some products may make a negative contribution – that is, variable costs may exceed the selling price – in which case, total profit may be increased by halting their production. However, sometimes firms may deliberately produce and sell a product generating a negative contribution as a loss-leader, in order to encourage interest in other products in the range. Closing down the production of such a product could damage sales of the other products, and reduce their contribution as well. For example, the Mini car is a popular make which car-dealers like to display in their showrooms to attract people in to browse – and hopefully to buy. However, for many years the production of the Mini resulted in a loss for its manufacturer.

Similarly, a product may make a negative contribution if it is a relatively new, competitively priced item, in the launch or growth stage of its life cycle.

Marginal cost pricing. The addition to total cost resulting from the production of an additional unit of output is known as the marginal cost. A decision to expand output by one or more units will be based on an assumption that unit price will be at least sufficient to cover marginal costs, such that the total profit earned on all previous units is not reduced. Sometimes firms will price just above marginal cost in order to use up spare capacity and ensure that at least a small contribution to fixed costs is made. For example, consider an airline selling flights to New York. Whether the plane flies full or half-empty, it will incur the same fixed costs for fuel, flight crew, and staff. Suppose 80% of seats at the standard fare are sold, yielding a reasonable profit on the flight. In an attempt to fill the plane, the airline can offer remaining seats at bargain prices. The marginal cost of each additional passenger will be small – just the cost of additional administration and on-board refreshments. As long as the fare price more than covers these small additional costs, the airline will be able to add to its profit.

Problems with cost-based pricing

Cost-based pricing strategies make no allowance for the market and what people are already paying for similar products. Once a mark-up for profit has been added on top of allocated costs per unit, the product price may be too expensive compared to rival products, and the firm will find it difficult to make sales. In the short run, therefore, a firm may be forced to cut price and take a loss in order to fight off competition.