Basic Marketing: A Global−Managerial Approach Chapter 18 ppt

When you think of the large number of itemsthe average retailer and wholesaler carry—and the small sales volume of any one Demand Chapter 18 Pricing objectives Chapter 17 Price of other

When You

Finish This Chapter,

You Should

1.Understand how

most wholesalers and

retailers set their

mar-ginal analysis and

how to use it for price

7.Know the many

ways that price

set-ters use demand

In the spring of 2001, Kmart’sprices on products like toothpaste,light bulbs, laundry soap, andbeauty products were 10 to 15percent higher than at Wal-Mart

Shoppers buy these items quently and know what they pay

fre-To provide equal value, marketingmanagers for Kmart decided thatthey needed to cut prices on 4,000

products And to highlight theirprice cutting they revived Kmart’shourly Blue Light Specials, a sur-prise sale on an item that usuallylasts about 15 minutes It didn’ttake long for Wal-Mart to announcethat it would be putting even moreemphasis on price rollbacks Bytaking a longer-term look at howWal-Mart has grown so fast in thepast, you’ll get a pretty good ideahow this wrestling match is going

to turn out

To put the big picture in tive, Wal-Mart’s current sales areabout five times Kmart’s By theyear 2005, Wal-Mart salesshould exceed $330 billion—

perspec-double what they were in 1999and 13 times what they were

in 1990 Back then, Wal-Martearned about twice as muchprofit as Kmart even though theyhad about the same sales revenue

What explains the big ence in growth and profitswhen the two chains are inmany ways similar? Part ofthe answer is that Wal-Marthas more sales volume ineach store Wal-Mart’s salesrevenue per square foot ismore than twice that at Kmart.

differ-Wal-Mart’s lower prices onsimilar products increasesdemand in its stores But it

also reduces its fixed ing costs as a percentage ofsales That means it can add asmaller markup, still cover itsoperating expenses, andmake a larger profit And aslower prices pull in more andmore customers, its percent ofoverhead costs to sales con-tinues to drop—from about20.2 percent in 1980 to about

inven-to reduce costs in the nel For example, Wal-Martwas one of the first majorretailers to insist that allorders be placed by com-puter; that helps to reducestock-outs on store shelvesand lost sales at the checkoutcounter Wal-Mart also workswith vendors to create private-label brands, such as Sam’sChoice Cola Its low price—about 15 percent below whatconsumers expect to pay forwell-known colas—doesn’tleave a big profit margin Yetwhen customers come in tobuy it they also pick up other,more profitable, products

514 Chapter 18

Even with its lower costs,

Wal-Mart isn’t content to take

the convenient route to price

setting by just adding a

stan-dard percentage markup on

different items The company

was one of the first retailers to

give managers in every

depart-ment in every store frequent,

detailed information about

what is selling and what isn’t

They drop items that are

col-lecting dust and roll back

prices on the ones with the

fastest turnover and highest

margins That not only

increases stockturn but also

puts the effort behind products

with the most potential For

example, every departmentmanager in every Wal-Martstore has a list of special VPIs(volume producing items)

They give VPIs special tion and display space—to get

atten-a bigger satten-ales atten-and profit boost

For instance, Wal-Mart’s sis of checkout-scanner salesdata revealed that parentsoften pick up more than onekid’s video at a time So nowthey are certain that specialdisplays feature several videosand that the rest of the selec-tion is close by

analy-Wal-Mart was the first majorretailer to move to online sell-ing (www.walmart.com) Its

online sales still account foronly a small percent of its totalsales, so there’s lots of room

to grow there too Further,Wal-Mart is aggressively tak-ing its low-price approach toother countries—ranging fromMexico to China

To return to where westarted, Kmart is now copyingmany of Wal-Mart’s innova-tions However, Wal-Mart hassuch advantages on sales vol-ume, unit costs, and marginsthat it will be difficult for Kmart

to win in any price war—unless Wal-Mart somehowstumbles because of itsenormous size.1

Price Setting Is a Key Strategy Decision

In the last chapter, we discussed the idea that pricing objectives and policiesshould guide pricing decisions We accepted the idea of a list price and went on todiscuss variations from list and how they combine to impact customer value Nowwe’ll see how the basic list price is set in the first place—based on information aboutcosts, demand, and profit margins See Exhibit 18-1

Many firms set a price by just adding a standard markup to the average cost ofthe products they sell But this is changing More managers are realizing that theyshould set prices by evaluating the effect of a price decision not only on profit mar-gin for a given item but also on demand and therefore on sales volume, costs, andtotal profit In Wal-Mart’s very competitive markets, this approach often leads to

low prices that increase profits and at the same time reduce customers’ costs For

other firms in different market situations, careful price setting leads to a premiumprice for a marketing mix that offers customers unique benefits and value But thesefirms commonly focus on setting prices that earn attractive profits—as part of anoverall marketing strategy that satisfies customers’ needs

There are many ways to set list prices But for simplicity they can be reduced to

two basic approaches: cost-oriented and demand-oriented price setting We will discuss

cost-oriented approaches first because they are most common Also, understandingthe problems of relying only on a cost-oriented approach shows why a marketingmanager must also consider demand to make good Price decisions Let’s begin bylooking at how most retailers and wholesalers set cost-oriented prices

Some Firms Just Use Markups

Some firms, including most retailers and wholesalers, set prices by using a

markup—a dollar amount added to the cost of products to get the selling price Forexample, suppose that a CVS drugstore buys a bottle of Pert Plus shampoo for $2

To make a profit, the drugstore obviously must sell the shampoo for more than $2

If it adds $1 to cover operating expenses and provide a profit, we say that the store

is marking up the item $1

Markups, however, usually are stated as percentages rather than dollar amounts.And this is where confusion sometimes arises Is a markup of $1 on a cost of $2 amarkup of 50 percent? Or should the markup be figured as a percentage of the sell-ing price—$3.00—and therefore be 331⁄3percent? A clear definition is necessary.Unless otherwise stated, markup (percent)means percentage of selling price that

is added to the cost to get the selling price So the $1 markup on the $3.00 sellingprice is a markup of 331⁄3 percent Markups are related to selling price forconvenience

There’s nothing wrong with the idea of markup on cost However, to avoidconfusion, it’s important to state clearly which markup percent you’re using.Managers often want to change a markup on cost to one based on selling price,

or vice versa The calculations used to do this are simple (See the section onmarkup conversion in Appendix B on marketing arithmetic The appendixes followChapter 22.)2

Many middlemen select a standard markup percent and then apply it to all theirproducts This makes pricing easier When you think of the large number of itemsthe average retailer and wholesaler carry—and the small sales volume of any one

Demand (Chapter 18)

Pricing objectives (Chapter 17)

Price of other products in the line (Chapter 18)

Price flexibility (Chapter 17)

Discounts and allowances (Chapter 17)

Legal environment (Chapter 17)

Cost (Chapter 18)

Competition (Chapter 18)

Geographic pricing terms (Chapter 17)

Markup chain

in channels (Chapter 18)

Price setting

516 Chapter 18

item—this approach may make sense Spending the time to find the best price tocharge on every item in stock (day to day or week to week) might not pay.Moreover, different companies in the same line of business often use the samemarkup percent There is a reason for this: Their operating expenses are usually sim-ilar So a standard markup is acceptable as long as it’s large enough to cover thefirm’s operating expenses and provide a reasonable profit

How does a manager decide on a standard markup in the first place? A standard

markup is often set close to the firm’s gross margin Managers regularly see gross

mar-gins on their operating (profit and loss) statements The gross margin is the amountleft—after subtracting the cost of sales (cost of goods sold) from net sales—to coverthe expenses of selling products and operating the business (See Appendix B onmarketing arithmetic if you are unfamiliar with these ideas.) Our CVS managerknows that there won’t be any profit if the gross margin is not large enough Forthis reason, CVS might accept a markup percent on Pert Plus shampoo that is close

to the store’s usual gross margin percent

Smart producers pay attention to the gross margins and standard markups of dlemen in their channel They usually allow trade (functional) discounts similar tothe standard markups these middlemen expect

mid-Different firms in a channel often usedifferent markups A markup chain—thesequence of markups firms use at differ-ent levels in a channel—determines theprice structure in the whole channel The

markup is figured on the selling price at

each level of the channel

For example, Black & Decker’s sellingprice for an electric drill becomes thecost the Ace Hardware wholesaler pays.The wholesaler’s selling price becomesthe hardware retailer’s cost And this costplus a retail markup becomes the retail selling price Each markup should cover thecosts of running the business and leave a profit

Specialized products that rely on

selective distribution and sell in

smaller volume usually offer

retailers higher markups, in part

to offset the retailer’s higher

carrying costs and marketing

expenses.

Markups are related to

gross margins

Markup chain may be

used in channel pricing

Exhibit 18-2 illustrates the markup chain for an electric drill at each level of thechannel system The production (factory) cost of the drill is $21.60 In this case, theproducer takes a 10 percent markup and sells the product for $24 The markup is 10percent of $24 or $2.40 The producer’s selling price now becomes the wholesaler’scost—$24 If the wholesaler is used to taking a 20 percent markup on selling price,the markup is $6—and the wholesaler’s selling price becomes $30 The $30 nowbecomes the cost for the hardware retailer And a retailer who is used to a 40 percentmarkup adds $20, and the retail selling price becomes $50.

Some people, including many conventional retailers, think high markups meanbig profits Often this isn’t true A high markup may result in a price that’s toohigh—a price at which few customers will buy You can’t earn much if you don’tsell much, no matter how high your markup But many retailers and wholesalersseem more concerned with the size of their markup on a single item than with theirtotal profit And their high markups may lead to low profits or even losses.Some retailers and wholesalers, however, try to speed turnover to increase profit—even if this means reducing their markups They realize that a business runs up costsover time If they can sell a much greater amount in the same time period, they may

be able to take a lower markup and still earn higher profits at the end of the period

An important idea here is the stockturn rate—the number of times the averageinventory is sold in a year Various methods of figuring stockturn rates can be used(see the section “Computing the Stockturn Rate” in Appendix B) A low stockturnrate may be bad for profits

At the very least, a low stockturn increases inventory carrying cost and ties upworking capital If a firm with a stockturn of 1 (once per year) sells products thatcost it $100,000, it has that much tied up in inventory all the time But a stock-turn of 5 requires only $20,000 worth of inventory ($100,000 cost  5 turnovers

a year) If annual inventory carrying cost is about 20 percent of the inventoryvalue, that reduces costs by $16,000 a year That’s a big difference on $100,000

dollars

Producer Cost
$21.60
90% Markup
$2.40
10%

Exhibit 18-2 Example of a Markup Chain and Channel Pricing

High markups don’t

always mean big

profits

Lower markups can

speed turnover and the

stockturn rate

518 Chapter 18

Although some middlemen use the same standard markup percent on all theirproducts, this policy ignores the importance of fast turnover Mass-merchandisersknow this They put low markups on fast-selling items and higher markups on itemsthat sell less frequently For example, Wal-Mart may put a small markup on fast-selling health and beauty aids (like toothpaste or shampoo) but higher markups onappliances and clothing Similarly, supermarket operators put low markups on fast-selling items like milk, eggs, and detergents The markup on these items may be lessthan half the average markup for all grocery items, but this doesn’t mean they’reunprofitable The store earns the small profit per unit more often

Some markups eventually become standard in a trade Most channel memberstend to follow a similar process—adding a certain percentage to the previous price.But who sets price in the first place? The firm that brands a product is usually theone that sets its basic list price It may be a large retailer, a large wholesaler, or mostoften, the producer

Some producers just start with a cost per unit figure and add a markup—perhaps

a standard markup—to obtain their selling price Or they may use some of-thumb formula such as:

rule-Selling price
Average production cost per unit  3

A producer who uses this approach might develop rules and markups related toits own costs and objectives Yet even the first step—selecting the appropriate costper unit to build on—isn’t easy Let’s discuss several approaches to see how cost-oriented price setting really works

Average-Cost Pricing Is Common and Can Be Dangerous

This trade ad, targeted at

retailers, emphasizes faster

stockturn which, together with

markups, impacts the retailer’s

profitability.

Mass-merchandisers

run in fast company

Where does the

markup chain start?

Average-cost pricingmeans adding a reasonable markup to the average cost of

a product A manager usually finds the average cost per unit by studying pastrecords Dividing the total cost for the last year by all the units produced and sold

in that period gives an estimate of the average cost per unit for the next year Ifthe cost was $32,000 for all labor and materials and $30,000 for fixed overheadexpenses—such as selling expenses, rent, and manager salaries—then the total cost

is $62,000 If the company produced 40,000 items in that time period, the age cost is $62,000 divided by 40,000 units, or $1.55 per unit To get the price,the producer decides how much profit per unit to add to the average cost per unit

aver-If the company considers 45 cents a reasonable profit for each unit, it sets the newprice at $2.00 Exhibit 18-3A shows that this approach produces the desiredprofit—if the company sells 40,000 units

It’s always a useful input to pricing decisions to understand how costs operate atdifferent levels of output Further, average-cost pricing is simple But it can also bedangerous It’s easy to lose money with average-cost pricing To see why, let’s fol-low this example further

First, remember that the average cost of $2.00 per unit was based on output

of 40,000 units But if the firm is only able to produce and sell 20,000 units inthe next year, it may be in trouble Twenty thousand units sold at $2.00 each($1.55 cost plus 45 cents for expected profit) yield a total revenue of only

$40,000 The overhead is still fixed at $30,000, and the variable material andlabor cost drops by half to $16,000—for a total cost of $46,000 This means aloss of $6,000, or 30 cents a unit The method that was supposed to allow a profit

of 45 cents a unit actually causes a loss of 30 cents a unit! See Exhibit 18-3B.The basic problem with the average-cost approach is that it doesn’t considercost variations at different levels of output In a typical situation, costs are highwith low output, and then economies of scale set in—the average cost per unitdrops as the quantity produced increases This is why mass production and massdistribution often make sense It’s also why it’s important to develop a better under-standing of the different types of costs a marketing manager should consider whensetting a price

Exhibit 18-3 Results of Average-Cost Pricing

A Calculation of Planned Profit if 40,000 B Calculation of Actual Profit if Only 20,000

Fixed overhead expenses $30,000 Fixed overhead expenses $30,000

Labor and materials ($.80 a unit) 32,000 Labor and materials ($.80 a unit) 16,000

Total costs and planned profit $80,000

Calculation of Profit (or Loss): Calculation of Profit (or Loss):

Actual unit sales  price ($2.00*) $80,000 Actual unit sales  price ($2.00*) $40,000

It does not make

allowances for cost

variations as output

changes

520 Chapter 18

520

Average-cost pricing may lead to losses because there are a variety of costs—and

each changes in a different way as output changes Any pricing method that uses cost

must consider these changes To understand why, we need to define six types of costs

1 Total fixed costis the sum of those costs that are fixed in total—no matterhow much is produced Among these fixed costs are rent, depreciation, man-agers’ salaries, property taxes, and insurance Such costs stay the same even ifproduction stops temporarily

2 Total variable cost,on the other hand, is the sum of those changing expensesthat are closely related to output—expenses for parts, wages, packaging materi-als, outgoing freight, and sales commissions

At zero output, total variable cost is zero As output increases, so do variablecosts If Levi’s doubles its output of jeans in a year, its total cost for denim clothalso (roughly) doubles

3 Total costis the sum of total fixed and total variable costs Changes in total costdepend on variations in total variable cost—since total fixed cost stays the same.The pricing manager usually is more interested in cost per unit than total costbecause prices are usually quoted per unit

1 Average cost(per unit) is obtained by dividing total cost by the relatedquantity (that is, the total quantity that causes the total cost)

Marketing Manager Must Consider Various Kinds of Costs

Are Women Consumers Being Taken to the Cleaners?

Women have complained for years that they pay

more than men for clothes alterations, dry cleaning,

shirt laundering, haircuts, shoes, and a host of other

products For example, a laundry might charge $2.25

to launder a woman’s white cotton shirt and charge

only $1.25 for an identical shirt delivered by a man.

A survey by a state agency in California found that

of 25 randomly chosen dry cleaners, 64 percent

charged more to launder women’s cotton shirts than

men’s; 28 percent charged more to dry clean

women’s suits And 40 percent of 25 hair salons

sur-veyed charged more for basic women’s haircuts.

Soon after the survey, California passed a law

ban-ning such gender-based differences in prices—and

New York and Massachusetts followed suit An

infor-mal study by KRON-TV confirmed that pricing

differences continued to be common in California.

Publicity about the $1,000 fine for violations may

change that On the other hand, there’s nothing in any

law to say that Mennen antiperspirant for men, priced

at $2.89 for 2.25 ounces, can’t be a better deal than

Mennen’s Lady Speed Stick, which is $2.69 for

one-third fewer ounces Such differences are common

with health and beauty aids.

Some consumers feel that such differences in

pricing are unethical Critics argue that firms are

dis-criminating against women by arbitrarily charging

them higher prices Not everyone shares this view A spokesperson for an association of launderers and cleaners says that “the automated equipment we use fits a certain range of standardized shirts A lot of women’s blouses have different kinds of trim and lots of braid work, and it all has to be hand-finished If

it involves hand-finishing, we charge more.” Some cleaners charge more for doing women’s blouses because the average cost is higher than the average cost for men’s shirts Some just charge more because women buy anyway.

There are no federal laws to regulate the prices that dry cleaners, hair salons, or tailors charge Still, most experts argue that such laws, including the state rules, are unnecessary After all, customers who don’t like a particular cleaner’s rates are free to visit a competitor who may charge less.

Many firms face the problem of how to set prices when the average costs are different to serve different customers For example, poor, inner-city consumers often pay higher prices for food But inner-city retail- ers also face higher average costs for facilities, shoplifting, and insurance Some firms don’t like to charge different consumers different prices, but they also don’t want to charge everyone a higher average price—to cover the expense of serving high-cost customers. 3

2 Average fixed cost(per unit) is obtained by dividing total fixed cost by therelated quantity.

3 Average variable cost(per unit) is obtained by dividing total variable cost bythe related quantity

A good way to get a feel for these different types of costs is to extend our cost pricing example (Exhibit 18-3A) Exhibit 18-4 shows the six types of cost andhow they vary at different levels of output The line for 40,000 units is highlightedbecause that was the expected level of sales in our average-cost pricing example Forsimplicity, we assume that average variable cost is the same for each unit Notice,however, that total variable cost increases when quantity increases

average-Average fixed costs are lower

when a larger quantity is

produced.

An example shows

cost relations

Exhibit 18-4 Cost Structure of a Firm

522 Chapter 18

Exhibit 18-5 shows the three average cost curves from Exhibit 18-4 Noticethat average fixed cost goes down steadily as the quantity increases Although theaverage variable cost remains the same, average cost decreases continually too.This is because average fixed cost is decreasing With these relations in mind, let’sreconsider the problem with average-cost pricing

Average-cost pricing works well if the firm actually sells the quantity it used toset the average-cost price Losses may result, however, if actual sales are much lowerthan expected On the other hand, if sales are much higher than expected, thenprofits may be very good But this will only happen by luck—because the firm’sdemand is much larger than expected

To use average-cost pricing, a marketing manager must make some estimate of

the quantity to be sold in the coming period Without a quantity estimate, it isn’tpossible to compute average cost But unless this quantity is related to price—that is, unless the firm’s demand curve is considered—the marketing manager mayset a price that doesn’t even cover a firm’s total cost! You saw this happen inExhibit 18-3B, when the firm’s price of $2.00 resulted in demand for only 20,000units and a loss of $6,000

The demand curve is still important even if management doesn’t take time tothink about it For example, Exhibit 18-6 shows the demand curve for the firm we’re

discussing This demand curve shows why the firm lost money when it tried to use

average-cost pricing At the $2.00 price, quantity demanded is only 20,000 Withthis demand curve and the costs in Exhibit 18-4, the firm will incur a loss whethermanagement sets the price at a high $3 or a low $1.20 At $3, the firm will sellonly 10,000 units for a total revenue of $30,000 But total cost will be $38,000—for a loss of $8,000 At the $1.20 price, it will sell 60,000 units—at a loss of $6,000.However, the curve suggests that at a price of $1.65 consumers will demand about40,000 units, producing a profit of about $4,000

In short, average-cost pricing is simple in theory but often fails in practice In

stable situations, prices set by this method may yield profits but not necessarily

max-imum profits And note that such cost-based prices may be higher than a price that

would be more profitable for the firm, as shown in Exhibit 18-6 When demandconditions are changing, average-cost pricing is even more risky

Exhibit 18-7 summarizes the relationships discussed above Cost-oriented pricingrequires an estimate of the total number of units to be sold That estimate deter-

mines the average fixed cost per unit and thus the average total cost Then the firm

adds the desired profit per unit to the average total cost to get the cost-oriented ing price How customers react to that price determines the actual quantity the firmwill be able to sell But that quantity may not be the quantity used to compute the

sell-Ignoring demand is the

major weakness of

average-cost pricing

Average variable cost Average fixed cost

Quantity (000)

1.00

2.00 1.40 1.18

3.00

$4.00

Exhibit 18-5

Typical Shape of Cost

(per unit) Curves When

Average Variable Cost

per Unit Is Constant

average cost! Further, the quantity the firm actually sells (times price) determinestotal revenue (and total profit or loss) A decision made in one area affects each ofthe others, directly or indirectly Average-cost pricing does not consider these effects.4

A manager who forgets this can make serious pricing mistakes

Some aggressive firms use a variation of average-cost pricing called experiencecurve pricing Experience curve pricingis average-cost pricing using an estimate of

future average costs This approach is based on the observation that over time—as

an industry gains experience in certain kinds of production—managers learn newways to reduce costs In some industries, costs decrease about 15 to 20 percent eachtime cumulative production volume (experience) doubles So a firm might setaverage-cost prices based on where it expects costs to be when products are sold inthe future—not where costs actually are when the strategy is set This approach is

Total revenue
Price x Quantity $30,000
$3.00 x 10,000 $40,000
$2.00 x 20,000 $57,000
$1.90 x 30,000 $66,000
$1.65 x 40,000 $75,000
$1.50 x 50,000 $72,000
$1.20 x 60,000

Quantity (000)

1.20 1.50 1.65 1.90 2.00

$3.00

Exhibit 18-6

Evaluation of Various Prices

along a Firm’s Demand

Curve

Experience curve

pricing is even riskier

Cost-oriented selling price per unit

Quantity demanded

at selling price

?

Average total cost per unit

Profit per unit

Average fixed cost per unit

Variable cost per unit

Estimated quantity

to be sold

Exhibit 18-7

Summary of Relationships

among Quantity, Cost, and

Price Using Cost-Oriented

Pricing

Some Firms Add a Target Return to Cost

Don’t ignore

competitors’ costs

Target return pricing—adding a target return to the cost of a product—hasbecome popular in recent years With this approach, the price setter seeks to earn(1) a percentage return (say, 10 percent per year) on the investment or (2) a specifictotal dollar return

This method is a variation of the average-cost method since the desired targetreturn is added into total cost As a simple example, if a company had $180,000invested and wanted to make a 10 percent return on investment, it would add

$18,000 to its annual total costs in setting prices

This approach has the same weakness as other average-cost pricing methods Ifthe quantity actually sold is less than the quantity used to set the price, then thecompany doesn’t earn its target return—even though the target return seems to bepart of the price structure In fact, we already saw this in Exhibit 18-3 Rememberthat we added $18,000 as an expected profit, or target return But the return wasmuch lower when the expected quantity was not sold (It could be higher too—butonly if the quantity sold is much larger than expected.) Target return pricing clearlydoes not guarantee that a firm will hit the target

Managers in some larger firms who want toachieve a long-run target return objective useanother cost-oriented pricing approach—long-run target return pricing—adding a long-run averagetarget return to the cost of a product Instead ofestimating the quantity they expect to produce inany one year, they assume that during several years’time their plants will produce at, say, 80 percent ofcapacity They use this quantity when setting theirprices

Companies that take this longer-run viewassume that there will be recession years whensales drop below 80 percent of capacity For exam-ple, Owens-Corning Fiberglas sells insulation Inyears when there is little construction, output islow, and the firm does not earn the target return.But the company also has good years when it sells more insulation and exceeds thetarget return Over the long run, Owens-Corning managers expect to achieve thetarget return And sometimes they’re right—depending on how accurately theyestimate demand!

Target return pricing

scores sometimes

Hitting the target in the

long run

Some price setters use break-even analysis in their pricing Break-even analysisevaluates whether the firm will be able to break even—that is, cover all its costs—with a particular price This is important because a firm must cover all costs in thelong run or there is not much point being in business This method focuses on the

break-even point (BEP)—the quantity where the firm’s total cost will just equal itstotal revenue

To help understand how break-even analysis works, look at Exhibit 18-8, an

example of the typical break-even chart The chart is based on a particular selling

price—in this case $1.20 a unit The chart has lines that show total costs (totalvariable plus total fixed costs) and total revenues at different levels of production.The break-even point on the chart is at 75,000 units—where the total cost andtotal revenue lines intersect At that production level, total cost and total revenueare the same—$90,000

The difference between the total revenue and total cost at a given quantity is theprofit—or loss! The chart shows that below the break-even point, total cost is higherthan total revenue and the firm incurs a loss The firm would make a profit above thebreak-even point However, the firm would only reach the break-even point, or get

beyond it into the profit area, if it could sell at least 75,000 units at the $1.20 price.

Break-even analysis can be very helpful if used properly, so let’s look at thisapproach more closely

A break-even chart is an easy-to-understand visual aid, but it’s also useful to beable to compute the break-even point

The BEP, in units, can be found by dividing total fixed costs (TFC) by the

fixed-cost (FC) contribution per unit—the assumed selling price per unit minus thevariable cost per unit This can be stated as a simple formula:

Total fixed costBEP (in units)

Fixed cost contribution per unitThis formula makes sense when we think about it To break even, we must covertotal fixed costs Therefore, we must figure the contribution each unit will make tocovering the total fixed costs (after paying for the variable costs to produce the

Break-Even Analysis Can Evaluate Possible Prices

Break-even charts help

Total cost curve

Total variable costs

Total fixed costs Loss area

Profit area

0

10 20 30 40 50 60 70 80 90100 10

20 30 40 50 60 70 80

100 90

Units of production (000)

Exhibit 18-8

Break-Even Chart for a

Particular Situation

526 Chapter 18

item) When we divide this per-unit contribution into the total fixed costs that must

be covered, we have the BEP (in units)

To illustrate the formula, let’s use the cost and price information in Exhibit 18-8.The price per unit is $1.20 The average variable cost per unit is 80 cents So the

FC contribution per unit is 40 cents ($1.20 80 cents) The total fixed cost is

$30,000 (see Exhibit 18-8) Substituting in the formula:

BEP
$30,000
75,000 units.40From this you can see that if this firm sells 75,000 units, it will exactly cover allits fixed and variable costs If it sells even one more unit, it will begin to show aprofit—in this case, 40 cents per unit Note that once the fixed costs are covered,

the part of revenue formerly going to cover fixed costs is now all profit.

The BEP can also be figured in dollars The easiest way is to compute the BEP

in units and then multiply by the assumed per-unit price If you multiply the ing price ($1.20) by the BEP in units (75,000) you get $90,000—the BEP in dollars.Often it’s useful to compute the break-even point for each of several possibleprices and then compare the BEP for each price to likely demand at that price Themarketing manager can quickly reject some price possibilities when the expectedquantity demanded at a given price is way below the break-even point for that price

sell-So far in our discussion of BEP we’ve focused on the quantity at which total enue equals total cost—where profit is zero We can also vary this approach to see whatquantity is required to earn a certain level of profit The analysis is the same as describedabove for the break-even point in units, but the amount of target profit is added to thetotal fixed cost Then when we divide the total fixed cost plus profit figure by thecontribution from each unit, we get the quantity that will earn the target profit.Break-even analysis makes it clear why managers must constantly look for effec-tive new ways to get jobs done at lower costs For example, if a manager can reducethe firm’s total fixed costs—perhaps by using computer systems to cut out excess

rev-BEP can be stated in

dollars too

Each possible price

has its own break-even

The money that a firm spends on

marketing and other expenses

must be at least covered by a

firm’s price if it is to make a

profit That’s why Gillette enjoys

big economies of scale by selling

the same razors in every market.

inventory carrying costs—the break-even point will be lower and profits will start tobuild sooner Similarly, if the variable cost to produce and sell an item can be reduced,the fixed-cost contribution per unit increases; that too lowers the break-even pointand profit accumulates faster for each product sold beyond the break-even point.Break-even analysis is helpful for evaluating alternatives It is also popularbecause it’s easy to use Yet break-even analysis is too often misunderstood Beyondthe BEP, profits seem to be growing continually And the graph—with its straight-line total revenue curve—makes it seem that any quantity can be sold at theassumed price But this usually isn’t true It is the same as assuming a perfectly hor-izontal demand curve at that price In fact, most managers face down-sloping

demand situations And their total revenue curves do not keep going up.

The firm and costs we discussed in the average-cost pricing example earlier inthis chapter illustrate this point You can confirm from Exhibit 18-4 that the totalfixed cost ($30,000) and average variable cost (80 cents) for that firm are the sameones shown in the break-even chart (Exhibit 18-8) So this break-even chart is theone we would draw for that firm assuming a price of $1.20 a unit But the demandcurve for that case showed that the firm could only sell 60,000 units at a price of

$1.20 So that firm would never reach the 75,000 unit break-even point at a $1.20price It would only sell 60,000 units, and it would lose $6,000! A firm with adifferent demand curve—say, one where the firm could sell 80,000 units at a price

of $1.20—would in fact break even at 75,000 units

Break-even analysis is a useful tool for analyzing costs and evaluating what mighthappen to profits in different market environments But it is a cost-orientedapproach and suffers the same limitation as other cost-oriented approaches Specif-ically, it does not consider the effect of price on the quantity that consumers willwant—that is, the demand curve

So to really zero in on the most profitable price, marketers are better offestimating the demand curve itself and then using marginal analysis, which we’lldiscuss next.6

Marginal Analysis Considers Both Costs and Demand

Break-even analysis is

helpful —but not a

pricing solution

The best pricing tool marketers have for looking at costs and revenue (demand)

at the same time is marginal analysis Marginal analysis focuses on the changes intotal revenue and total cost from selling one more unit to find the most profitableprice and quantity Marginal analysis shows how profit changes at different prices

Thus, it can help to find the price that maximizes profit You can also see the effect

of other price levels Even if you adjust to pursue objectives other than profitmaximization, you know how much profit you’re giving up!

To explain how marginal analysis works, we’ll use an example based on a firmwith the specific cost and demand numbers in Exhibit 18-9 This example uses sim-ple numbers to ensure that the explanations are easy to follow However, theapproach we cover is the same one that managers use A manager who works withlarge numbers might use spreadsheet software to do the calculations and create atable like the one shown in Exhibit 18-9 However, as you’ll see in the example,only basic adding, subtracting, multiplying, and dividing are required

Our example and discussion focus on a firm that operates in a market where there

is monopolistic competition As we noted in Chapter 17, in this situation the keting manager does have a pricing decision to make, and the firm can carve out amarket niche for itself with the price and marketing mix it offers.7

mar-Marginal analysis helps

find the right price

Marginal analysis when

demand curves slope

down