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What Is a Break-Even Price?
A break-even price is the price at which an asset, if sold, would pay for the costs of ownership. Any amount beyond the break-even price is profit.
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 price of the underlying asset at which investors can choose to exercise or dispose of the contract without incurring a loss.
Key Takeaways
- A break-even price describes a change in value that matches an initial investment or cost.
- For an options contract, the break-even price is the price level at which an underlying security covers an option’s premium.
- In manufacturing, the break-even price is the price at which the cost to manufacture a product is equal to its sale price.
- Break-even pricing is often used as a competitive strategy to gain market share, but a break-even price strategy can lead to the perception that a product is of low quality.
Understanding Break-Even Prices
Break-even prices can be applied to almost any transaction.
For example, the break-even price of a house would be a sale price that equals the home’s purchase price, mortgage interest paid, 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.
Traders also use break-even prices to understand where a securities price must go to make a trade profitable after costs, fees, and taxes have been taken into account.
Break-Even Price Formula
Mathematically, the break-even price is the amount of monetary receipts that equals the amount of monetary contributions.
With sales matching costs, the related transaction is said to break even, sustaining no losses and earning no profits in the process.
To determine a break-even price, a person simply uses the total cost of a business or financial activity or transaction as the target price at which to sell a product, service, or financial security.
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.
Thus, a good produced for $20 total would need to sell for $20 exactly.
Another way to compute the total break-even for a firm is to divide the gross profit margin by total fixed costs:
Business break-even = gross profit margin / fixed costs
For an options contract, such as a call or a put, the break-even price is that price at which the underlying security 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
Break-Even Price Strategy
Break-even price as a business strategy is most 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 may be achieved at the expense of 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 can be used to estimate 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 of transacting at the break-even price.
In addition to gaining market share and driving away existing competition, 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 is not as valuable as other products. This 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 race-to-the-bottom pricing, losses can be incurred when break-even prices give way to even lower prices.
Fast Fact
Both marginalist and Marxist theories predict that due to competition, firms will always be under pressure to sell their goods at the break-even price, implying no room for long-run profits.
Examples of Break-Even Prices
Suppose firm ABC manufactures widgets. The total costs for making a widget per unit can be broken down as follows:
| Widget Cost | |
|---|---|
| Direct Labor | $5 |
| Materials | $2 |
| Manufacture | $3 |
Hence, the break-even price ABC needs to recover costs 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
(200,000 / 10,000) + 10
20 + 10 = 30
$30 is the break-even price for the firm if it manufactures 10,000 widgets. Using the same formula, the break-even price for manufacturing 20,000 widgets is $20.
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, anything below would imply a net loss.
How Can Ordinary Individuals Use Break-Even Prices?
The break-even price covers the cost or initial investment in something. For example, if you sell your house for exactly what you still need to pay, you would be left with zero debt but no profit. Investors who are holding a losing stock position can use an options repair strategy to break even on their investment quickly. Break-even price calculations can look different depending on the specific industry or scenario. However, the overall definition remains the same.
What Is the Break-even Price for an Options Contract?
In general, the break-even price for an options contract will be the strike price plus the cost of the premium. For a $20-strike call option that cost $2, the break-even price would be $22. For a put option with the same details, the break-even price would instead be $18.
Why Should Taxes and Fees Be Included in a Break-Even Analysis?
A gross break-even point may not be accurate enough for such analysis because taxes, fees, and other charges are often involved and must be taken into account. For instance, if you sell a stock for a $10 profit subject to long-term capital gains tax, you will have to pay $1.50 in taxes. If the commission was $1 for the trade, that also must be noted. Inflation, too, is something to consider, especially for long-term holdings.
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