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Break-even Pricing, Revenue and Units

Joe Parcell, Nancy Giddens, and Melvin Brees
Department of Agricultural Economics

This publication presents a method for determining the break-even price, revenue and unit sales of value-added agricultural products. Although this method can be applied to any product, this publication is developed from the perspective of a producer in a post-farmgate business. This publication is designed to help producers understand how to establish the break-even price, revenue, and units sold from a cost perspective. While break-even revenue and units sold are calculated for making financial and management decisions, break-even pricing is calculated to assist in helping market the product. Break-even pricing is important for producer-owners of value-added businesses because they need to know how to price a product as compared with pricing a commodity.

Determining the cost of production

Producer-owners of value-added businesses must assess the profit potential of their new business by its competitiveness in the market. Profit potential is calculated by computing production costs, establishing an expected selling price based on substitute goods, and determining whether the product can be produced for that price. Price premiums are based on end-user demand and profit goals. Much of this discussion also applies to producing commodities in the farm business. However, commodity producers are price takers and not price makers. The producer-owned, value-added business should operate as a price maker.

Typically there are two costs associated with production: variable and fixed costs.

  • Variable costs: Increase directly in proportion to the level of sales. Some examples are the cost of creating the good, shipping charges, delivery charges, costs of direct materials or supplies, and wages of part-time employees.
  • Fixed costs: Remain the same regardless of your level of sales. Some examples include rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of full-time workers.

Ideally, the budgeting process allocates all costs evenly across production units. However, the reality is that projecting unit sales is difficult. Businesses typically err by overestimating demand. Sales lower than expected sales result in an increased per-unit cost of products sold. To cover this error, many producers reduce their owner salary so that outside income subsidizes the business. With a producer-owned, value-added business, one may find the farm business subsidizing operation of the value-added business, or vice versa. While businesses are encouraged to be optimistic in their projections, developing a sensitivity analysis table is suggested. Sensitivity analysis tables show expected break-even price, revenue, and unit levels from ranges of decision variables. This allows the value-added business owner to determine best- and worst-case scenarios.

Break-even price

In commodity agriculture, the break-even price is referred to as the per-unit cost of production. As commodity price takers, farmers develop marketing plans to obtain a price that is higher than their per-unit cost of production. For instance, if a producer produces 20,000 bushels of corn, then knowing the variable and fixed cost of production easily provides the per-unit cost of production, and the producer would sell when the market (market price plus government subsidies) is above the per-unit cost of production. Just as the producer in the example sets prices based on per-unit cost of production, value-added businesses, or price maker businesses, set prices after calculating their break-even price.

CandleThe break-even pricing method is applied to the example of producing soybean candles (Table 1). To compute the break-even price for the fictitious Soy Candles, L.L.C., it is necessary to project the number of units sold. This can be tricky. A poor projection can cause the calculated break-even price to vary significantly.
 

Table 1
Establishing the break-even price for soybean candles manufactured by Soy Candles, L.L.C.

  • Based on an initial purchase price of $22,000 with a 20-year payback period.
  • Based on an initial purchase price of $14,000 with a 7-year payback period.
  • Based on a 20-year loan for buildings and 7-year loan for equipment with 25 percent down and an 8 percent interest rate.
Item Explanation
Variable costs per unit
Soy oil Candle creation $0.25
Wicks Candle creation $0.05
Wax Candle creation $0.15
Jars Candle packaging $0.30
Lids Candle packaging $0.05
Labels Candle marketing $0.10
Boxes Candle shipping $0.45
Miscellaneous   $0.10
Total variable cost   $1.45
Total fixed costs
Insurance Liability insurance $1,000
Advertising Promotion, Web presence, and radio spots $4,000
Utilities Lights, phones, heating, and cooling $2,500
Buildings1 Purchased building where candle production occurs $1,100
Equipment2 Equipment used in the production of candles $2,000
Interest paid Interest payment for first year of operation3 $2,160
Salary Owner target salary of $25,000 annually, plus fringe benefits $32,000
Total fixed cost   $44,760

Soy Candles, L.L.C. projects sales of 20,000 units next year. From Table 1, the per-unit variable cost is $1.45. Fixed cost is $44,760. Use the following equation to calculate the break-even price.

Break-even price equals

  • Variable cost per unit + (Total fixed cost/Projected unit sales)
  • $1.45 + ($44,760/20,000)
  • $3.69

Table 2 summarizes the break-even prices computed for different projected unit sales. For projected unit sales of 20,000 units, the break-even price is $3.69 per candle. Suppose actual unit sales reach only 18,000 units. Then, the break-even price should have been $3.94. If the candles were underpriced by $0.25, revenue would decline by $4,000 (20,000 units 3 $0.25 per unit).

Table 2
Break-even price sensitivity around changes in annual projected unit sales.

Projected unit sales 18,000 19,000 20,000 21,000 22,000
Variable cost per unit $1.45 $1.45 $1.45 $1.45 $1.45
Total fixed cost $44,760 $44,760 $44,760 $44,760 $44,760
Fixed cost per unit $2.49 $2.36 $2.24 $2.13 $2.03
Break-even price $3.94 $3.81 $3.69 $3.58 $3.48

Even for small differences between the expected and the actual number of units sold, the break-even price changes substantially. For large quantities, variable cost per unit may differ because of purchasing volume discounts of inputs. However, for this example, variable cost is held constant because target sales are 20,000 candles, and inventory shortage or surplus could be adjusted by ordering more inventory or carrying inventory forward to the next year. After the projected break-even price is projected a markup pricing strategy must be set. Once a producer has projected an asking price, break-even revenue and units can be determined.

Break-even revenue

Break-even revenue is computed from the selling price and from variable and fixed costs to determine the amount of revenue needed so that the business neither makes nor losses money.

The selling price is based on market research and prices of substitute goods. In the example of 20,000 unit sales of soybean candles, suppose the variable cost per unit is $1.45 and the selling price per unit is $5.

Break-even revenue equals

  • Fixed costs/[1 - (Variable cost per unit/Selling price per unit)]
  • $44,760/[1 - ( $1.45/$5)]
  • $63,042.25

For Soy Candle, L.L.C. to break even, revenue for the year must total $63,042.25. Table 3 is a sensitivity table for break-even revenue for alternative selling prices.

Table 3
Break-even revenue sensitivity around changes in selling price.

Projected selling price $4.50 $4.75 $5.00 $5.25 $5.50
Variable cost per unit $1.45 $1.45 $1.45 $1.45 $1.45
Total fixed cost $44,760 $44,760 $44,760 $44,760 $44,760
Break-even revenue $66,039.34 $64,427.27 $63,042.25 $61,839.47 $60,785.19

Break-even sales units

Calculate break-even sales from the selling price and the variable and fixed costs to determine the amount of unit sales needed so that the business neither makes nor losses money.

The selling price is established based on market research and prices of substitute goods. For the example of soybean candles, suppose the variable cost per unit is $1.45 and the selling price per unit is $5.

For the Soy Candle, L.L.C. to break even, total unit sales for the year will have to be 12,608 units. Table 4 is a sensitivity table for break-even units for alternative selling prices.

Table 4
Break-even sales units sensitivity around changes in selling price.

Projected selling price $4.50 $4.75 $5.00 $5.25 $5.50
Variable cost per unit $1.45 $1.45 $1.45 $1.45 $1.45
Total fixed cost $44,760 $44,760 $44,760 $44,760 $44,760
Break-even units 14,675 13,564 12,608 11,779 11,052

Break-even sales units equals

  • Fixed costs/(Selling price per unit/Variable cost per unit)
  • $44,760/($5 - $1.45)
  • 12,608

The key to establishing break-even revenue, units sold, and price is to know production costs. Keys to profitability include knowing your break-even price and being realistic in your cost, price, and sales projections. A critical management aspect of producer-owned, value-added businesses is that producers are involved in the operation of two businesses — the farm business and the value-added business. Thus, it may be difficult to allocate costs between the farm and the value-added business. It is best to charge all input costs into the value-added business using market prices instead of your cost of production. Careful management and financial planning are required to ensure the long-term success of both businesses.

 


G648 Break-even Pricing, Revenue and Units | University of Missouri Extension