Answer: This is the method of cost-oriented pricing and is
also called target profit pricing. It uses the concept of break-even
chart, which exhibits the total cost and total revenue expected at different
levels of sales volume. The firm achieves break-even when the total revenue is
just equal to the total costs. Break-even chart is a managerial tool
that establishes the relationship between the three key decision
variables- cost, price, and sales volume.
Break even pricing
is the practice of setting a price point at which a business will earn zero
profits on a sale. The intention is to use low prices as a tool to gain market
share and drive competitors from the marketplace. By doing so, a company may be
able to increase its production volumes to such an extent that it can reduce
costs and then earn a profit at what had previously been the break-even price.
Alternatively, once it has driven out competitors, the company can raise its
prices sufficiently to earn a profit, but not so high that the increased price
is tempting for new market entrants. The concept is also useful for
establishing the lowest acceptable price, below which the seller will begin to
lose money on a sale. This information is useful when responding to a customer
that is demanding the lowest possible price.
The break-even price
can be calculated by the following formula:
(Total fixed cost /
Production unit volume) + Variable cost per unit
This calculation
allows you to calculate the price at which the business will earn exactly zero
profit, assuming that a certain number of units are sold. In practice, the
actual number of units sold will vary from expectations, so the true break-even
price may prove to be somewhat different.