What is the Break-Even Price?
Break-even price is the amount of money, or change in value, for which an asset must be sold to cover the costs of acquiring and owning it. It can also refer to the amount of money for which a product or service must be sold to cover the costs of manufacturing or providing it. In options trading, the break-even price is the stock price at which investors can choose to exercise or dispose of the contract without incurring a loss.
Understanding Break-Even Price
Break-even prices can be translated to almost any transaction. For example, the break-even price of a house would be the sale price at which the owner could cover the home's purchase price, interest paid on the mortgage, hazard insurance, property taxes, maintenance, improvements, closing costs and real estate sales commissions. At this price, the homeowner would not see any profit, but also would not lose any money.
Break-even price is also used in managerial economics to determine the costs of scaling a product's manufacturing capabilities. Typically, an increase in product manufacturing volumes translates to a decrease in break-even prices because costs are spread over more product quantity.
Break-Even Price Formula
The break-even price is mathematically the amount of monetary receipts that equal the amount of monetary contributions. With sales matching costs, the related transaction is said to be break-even, sustaining no losses and earning no profits in the process. To formulate the break-even price, a person simply uses the amount of the total cost of a business or financial activity as the target price to sell a product, service or asset, or trade a financial instrument with the goal to break even. For example, the break-even price for selling a product would be the sum of the unit's fixed cost and variable cost incurred to make the product.
For an options contract, such as a call or a put, the break-even price is that level in the underlying security that fully covers the option's premium (or cost). Also known as the break-even point (BEP), it can be represented by the following formulas for a call or put, respectively:
BEPcall = strike price + premium paid;
BEPput = strike price - premium paid.
- In manufacturing, the break-even price is the price at which the cost to manufacture a product is equal to its sale price. In an options contract, the break-even price is that level in an underlying security when it covers an option's premium.
- Break-even pricing is often used as a competitive strategy to gain market share.
- A break-even price strategy can lead to the perception that a product is of low quality.
Break-Even Price Strategy
Using break-even price as a business strategy is mostly common in new commercial ventures, especially if a product or service is not highly differentiated from those of competitors. By offering a relatively low break-even price without any margin markup, a business may have a better chance to gather more market share, even though this is achieved at the expense of making no profits at the time.
Being a cost leader and selling at the break-even price requires a business to have the financial resources to sustain periods of zero earnings. However, after establishing market dominance, a business may begin to raise prices when weak competitors can no longer undermine its higher-pricing efforts.
The following formula is used to calculate a firm's break-even point:
Fixed Costs / (Price - Variable Costs) = Break-Even Point in Units
The break-even point is equal to the total fixed costs divided by the difference between the unit price and variable costs.
Break-Even Price Effects
There are both positive and negative effects from transacting at the break-even price. In addition to gaining market shares and driving away existing competitions, pricing at break-even also helps set an entry barrier for new competitors to enter the market. Eventually, this leads to a controlling market position, due to reduced competition.
However, a product or service's comparably low price may create the perception that the product or service may not be as valuable, which could become an obstacle to raising prices later on. In the event that others engage in a price war, pricing at break-even would not be enough to help gain market control. With racing-to-the-bottom pricing, losses can be incurred when break-even prices give way to even lower prices.
Example of Break-Even Price
Suppose firm ABC manufactures widgets. The total costs for making a widget per unit can be broken down as follows:
Hence, the break-even price to recover costs for ABC is $10 per widget.
Now suppose that ABC becomes ambitious and is interested in making 10,000 such widgets. To do so, it will have to scale operations and make significant capital investments in factories and labor. The firm invests $200,000 in fixed costs, including building a factory and buying machines for manufacturing.
The firm's break-even price for each widget can be calculated as follows:
(Fixed costs)/(Number of units) + Price per unit
i.e., 200,000/10,000 + 10 = 30.
$30 is the break-even price for the firm to manufacture 10,000 widgets. The break-even price to manufacture 20,000 widgets is $20 using the same formula.
Break-Even Price for an Options Contract
For a call option with a strike price of $100 and a premium paid of $2.50, the break-even price that the stock would have to get to is $102.50; anything above that level would be pure profit.