The Foundation to Effective Pricing Strategy Development
Pricing strategies are often complex and make up the backbone of most business’s financial models, while also being one of the key levers in the marketing mix. We can find the foundations of effective pricing strategies, though, through fairly simple Breakeven Analysis by focusing on the basics.
This week, we’ll take a look at how we can set a starting benchmark for our pricing strategies by focusing on what it takes to keep the lights on.
This simple analysis begins with comparing your costs, broken out as fixed and variable, with your price to determine just how much business you need to do in order to keep your company above water.
Breakeven Point = Fixed Cost / (Price – Variable Costs)
What we’re looking at with this formula begins with a simple margin calculation: we need to determine how much revenue you’re leftover with at the unit level after accounting for what it takes to produce that unit. We oftentimes refer to this margin as a Contribution Margin because it does exactly that, it contributes to covering your remaining day-to-day business expenses that we refer to as Fixed Costs. These costs include various kinds of overhead expenses such as salaries, office rent or mortgage, marketing budgets, and more.
At this point, with simple division, we can determine the amount of units we need to sell to breakeven. It is only at this point that our company can begin to generate a net profit, once we have covered both our fixed and variable costs.
This first basic calculation provides you with two levers you can pull to begin forecasting and developing pricing strategies. You will need to evaluate your resulting breakeven point: Can we sell this many units? Can we produce this many units? Is there enough demand for us to breakeven? Likewise, you will need to understand the relationship between Pricing and your Breakeven Point.
If you determine you will not be able to sell enough units to meet your breakeven point, you will need to increase pricing in order to keep your business running. Conversely, you must familiarize yourself with your customers’ price sensitivity. If your customers are unwilling to tolerate a price increase, you will need to find a way to sell more units to compensate.
Ultimately, the key to utilizing Breakeven Analysis lies in your and your company’s ability to find the balancing point between pricing and sales.