What Is Break-Even Price?
Break-Even Price Definition
The breakeven price is the amount of money an investor must sell to regain the costs of buying and owning the asset. In other words, it could also be indicating the amount of money required to cover the costs of producing or providing a good or service.
Anything that you buy has a price, and when you eventually sell it, you will either leave with more or less money than before. Whether you make a profit, therefore, depends on how much money you have left.
Breakeven prices are vital as they allow consumers and investors to manage their risks, raising awareness about when they will make losses and lose out on profits.
Learning what breakeven prices are, why they are important and how you could use them in your trading strategies will allow you to become an even better investor.
Table of Contents
Break-Even Price Explained with Examples
The breakeven price is significant for any investor or firm because it is the price that they need to cover all of their total costs [1].
The breakeven price, also known as a break-even or often abbreviated as B/E in finance, indicates that the total revenue from an asset is equal to its total costs. In economics, people pretend as if this is the most logical thing in the world. Why? Because it is human [2].
Imagine that you run a pizzeria, and it costs you €5 to make a pizza. This cost includes all economic costs. In the case of the pizzeria, think about these costs to include the cost of the dough, the toppings, the prices of turning and keeping on the oven, and the labour costs.
When you eventually start selling the pizza, at what price would you at least want to sell that pizza? That is right - you may want to sell that pizza for €5 as well.
Suppose that you want to sell this pizza for a lower price, for instance, €4. In that case, you may end up with €4 in money coming in - but you have initially already exerted €5. You are left with less money than before, and you have just made a loss of €1.
It may be pretty easy when we simply look at a pizzeria.
What if it is a multinational corporation, like Apple? In that case, it becomes challenging to figure out the best costs and prices for the firm.
Nevertheless, figuring out the total costs for producing, say, an Apple iPhone would be the first step towards finding out the breakeven price. Creating an Apple iPhone would include expenses such as the resource and material costs, the labour costs, maintaining the production site, etc.
However, despite all of these different cost forms, the eventual breakeven price for which Apple should sell the iPhone exactly equals the initial costs of producing the iPhone.
The same principle applies to anything that you may want to buy. Suppose that you want to buy a stock for $50 per share. Assuming that there are no commission costs and other transaction costs, your total expenses would equal $50. If you sell the stock for $60, you would have made a $10 profit. If you sell the stock for $40, you have lost $10.
However, if you eventually sell the stock at $50, you would not have made any profits, nor have you made any losses. That is the point where you break even - the breakeven point (BEP).
Last example to make it stick - say that you want to buy a home and eventually, after a couple of years, you want to sell the house again for, hopefully, a reasonable price.
Things may be a little trickier when it comes to real estate because there are other costs in play that are important to consider. After all, buying a house includes a house price in itself and any insurance costs, interest payments, taxes, commissions, etc., that will have to be considered.
When you want to sell your house at some point, you would like to know that the price for which you are selling the home will equal the breakeven price - where you will not be losing any money.
How Break-Even Price Works
The principle of break-even prices is straightforward. However, from the examples above, we can see that this may not always be the case. Sometimes, the costs may be challenging to be determined - and similarly, the prices could also be hard to find.
That is why break-even prices can be determined mathematically.
When you are buying something - money is flowing out of your wallet, net worth, etc. When you sell what you have bought earlier, money will be flowing into your wallet, net worth, etc.
From a simplistic perspective, break-even prices work by 1) adding all costs of producing a good, delivering a service or purchasing an asset and 2) comparing with the eventual revenue gained from this decision. Both should then be equal to each other to determine the break-even price.
Whereas the production costs, in this case, may include both fixed fees and variable costs, the break-even price would consist of both cost types in the calculation [3]. As such, the general calculation for break-even prices can be shown as [4]:
BEP = (Fc/V) + Cv, Where
BEP = Break Even price
Fc = Fixed Cost
V = Unit Volume
Cv = Variable Cost per Unit
Take the following example to understand the calculation better. The standard of using break-even prices in producing a dress shirt considers this calculation as well.
Suppose that Firm ‘Shirtmania’ makes dress shirts for wild and adventurous people. They would like to introduce a new type of dress shirt that is easy to wear and maintain, named ‘Shirt Vibes’. The following costs for producing this shirt have been calculated:
Material costs: $20
Labour costs: $25
Manufacturing costs: $10
Cost per shirt: $10 + $25 + $20 = $55
Total fixed costs: $500,000
Suppose that Shirtmania wants to produce 50,000 shirts. The break-even sales price should then be:
Breakeven sales price = ($500,000/ 50,000) + $55 = $10 + $55 = $65
Now, suppose that Shirtmania wants to produce 75,000 shirts. The break-even sales price would then change to:
Breakeven sales price = ($500,000/ 75,000) + $55 = $61.67
One more example to make it clear. Suppose that Shirtmania wants to produce 100,000 shirts. The break-even sales price would then change to:
Breakeven sales price = ($500,000/ 100,000) + $55 = $60
You could note that the more products Shirtmania produces (i.e., the volume increases), the lower the break-even sales price becomes. That can be explained because the fixed costs are distributed over a higher amount of products, while the variable costs to produce the products remains equal.
Break-Even Prices & Options
Break-even prices also exist in options trading - after all, investors purchase the options contracts for a specific price [5]. This is also called the premium price.
When investors are buying an options contract, they are expecting that the price will move in a certain direction and that after expiry of the contract, the investor is provided with the opportunity to purchase a specific amount of that asset for an agreed amount - the strike price.
He or she in this case can expect the price to increase and buy a call option, or buy a put option when they expect the price to fall (assuming the simplified scenario; note that investors can also sell call or put options).
If you want to buy the call option, and you expect that the price will increase, you may want to make sure that your breakeven price is calculated already. Suppose that you want to buy an option contract giving you the right to buy 100 shares of Stock XKL (not a real ticker, by the way) that costs $50 per share.
The option contract costs $1 per share including a commission of say $10. Your total cost would then be:
Option cost = (option price x volume) + commission
= $1 x 100 shares + $10
= $110
Per share, the option cost is divided by the amount of shares to be:
Cost per option share = (total option cost/ volume)
= $110/ 100
= $1.10
The strike price gives you the right to buy the stock at a specific price, but suppose that you expect that the price of XKL stock will go up at a certain point - for instance, to $75 per share.
The option contract, however, shows that you can buy the stock for $50 per share after expiry - the strike price.
The break-even price is then the option contract cost per share and the eventual cost of the stock per share you can purchase.
BEPcall = option contract cost per share + stock price
= premium per share + strike price
= $1.10 + $50
Note that we are not looking at profits yet. The break-even price is merely the price where you, the investor, will not be losing money.
Suppose that instead of a call option contract you are purchasing, you are purchasing a put option. With this contract, you are expecting the price to fall and you are reserving the right to sell the stock after the contract has expired.
Assuming that in this case, you want to sell 100 shares of XKL for $50 per share. The option contract still costs:
Option cost = (option price x volume) + commission
= $1 x 100 share + $10
= $110
and the option costs $1.10 per share. After expiry, when you want to sell the stock at the strike price of $50 per share, you will have to subtract the option cost per share from whatever profits you are making. Therefore, in case of put options, to calculate the BEP, you will have to subtract the premium per share from the strike price:
BEPput = stock price - option contract cost per share
= strike price - premium
= $50 - $1.10
= $48.90
With this BEP, you will know at which point you will not be losing out on profits or making losses.
What It Means for Retail Investors
Knowing the break-even price and using it in any analysis will allow people to have an edge over those people who are not aware of the break-even prices.
Although it seems straightforward, using break-even prices will primarily show at what point the investor is not making losses.
After all, nobody really wants to lose, right?
The break-even price shows what the minimum price should be for entrepreneurs or salesmen to sell a product, without the costs being higher than the amount of money they bring in.
Using the break-even price, house sellers and buyers alike will know what the minimum price they will have to sell (or buy) the house for in order to not make any losses, including and considering all commissions and additional costs in the transaction.
Using the break-even price, investors will know what the minimum price should be when they are selling their stock after holding it over a certain period - also including all commissions and costs.
Using the break-even price, option traders will consider the costs of the stock they are allowed to buy, including the additional cost of the contract itself (see above).
Using the break-even price is primarily there to raise awareness of losses and profits.
However, some take break-even prices one step further and develop a pricing strategy out of it.
Break-Even Price Strategies
If a firm wants to sell its products, it wants to make profits. They then would calculate the costs of producing the product (or delivering the service) and they would then set a price in order to achieve that profit.
However, some firms are still new on the market, and they are selling a product that is already existing - or not that different from competitors. Consequently, when they would set a higher price for the product that they are selling, those unfamiliar with the brand or the product will be able to purchase a cheaper product [6].
What the firm is doing, is to trade-off current profits with current familiarity, reputation or market share. They are willing to make less profits, break-even with the costs, but hope to gain recognition from the public.
Using the break-even price, firms can become a cost leader - a firm or organisation that is set up to become the cheapest provider of that service or product.
However, it may seem easier said than done. After all, the firm is not making any profits. As a result, the firm will have to be able to sustain the sales at lower prices - because the profits are not there, but neither are the costs going to decrease any time soon.
Then, when firms have achieved a certain reputation or market share, they may decide to raise prices when other competitors cannot keep up with the lower prices anymore. This is another fantastic way of using break-even prices in pricing strategies of products and services.
Article Sources
[1] Michigan State University. “Breakeven Price.” Accessed 3 August 2021.
[2] Goodwin et al. “Economic behaviour and rationality” Chapter 7, page 1. Microeconomics in Context. Routledge, 2013. Accessed 5 August 2021.
[3] Minority Business Development Agency. “Break-Even Analysis: Know When You Can Expect A Profit.” Accessed 4 August 2021.
[4] The Economic Times. “Definition of ‘Break-Even Pricing.” Accessed 4 August 2021.
[5] US Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options.” Accessed 5 August 2021.
[6] Entrepreneur Europe. “How To Calculate Your Market Share and Breakeven Point.” Accessed 5 August 2021.
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