External factors influencing pricing decisions

Setting price with regard only to the costs of production ignores the constraints imposed by external factors such as:

• The level of consumer demand

• The amount of competition among producers

• Government intervention in product markets

4.2. 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:

TC = FC + VC,

where

TC – total costs

FC – fixed costs

VC – variable costs

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 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:

TR = FC + VC = TC,

where

TR – total revenue

FC – fixed costs

VC – variable costs

TC – 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:

TC = FC + VC = 200,000 + (5 x Q)

and:

TR = Price * 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 * Q) = 30 * Q

Thus, to solve the equation by finding Q:

200,000 = 25 * 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.