What is a Break-Even Price?
A 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 price in the underlying asset at which investors can choose to exercise or dispose of the contract without incurring a loss.
Key Insights
- A break-even price describes a change of value that corresponds to just covering one’s initial investment or cost.
- For an options contract, the break-even price is that level in an underlying security when it 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 it can lead to the perception that a product is of low quality.
Break-Even Prices Explained
The concept of break-even prices can be applied to nearly any transaction. For instance, 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 neither see a profit nor a loss.
In the realm of manufacturing, break-even prices are used to determine the costs of scaling product manufacturing capabilities. Typically, increasing product volumes translates to a decrease in break-even prices because costs are spread over a higher quantity.
Traders use break-even prices to determine where a security’s price must go for a trade to be profitable after costs, fees, and taxes are accounted for.
The Simple Math Behind Break-Even Prices
To formulate the break-even price, you look at the total cost of a business operation or financial activity and set it as the target price. 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. If it costs $20 to produce a good, and it sells for $20, that is the break-even price. Another way to compute the total break-even for a firm is to use the gross profit margin divided by total fixed costs:
- Business break-even = gross profit margin / fixed costs
For an options contract like a call or put, the break-even price fully covers the option’s premium (or cost). This concept can be represented with the following formulas for a call or put, respectively:
- BEP_Call = strike price + premium paid
- BEP_Put = strike price - premium paid
Break-Even Price Strategy: Thriving Amidst Competition
Break-even pricing as a business strategy is commonly seen in new ventures, especially when a product isn’t highly differentiated from others. By offering a break-even price, a business might gather more market share despite making no profit initially.
Being a cost leader and selling at a break-even price requires substantial financial resources to sustain periods of zero earnings. Once market dominance is established, a business can raise prices when competitors can no longer undermine its pricing efforts.
To estimate a firm’s break-even point, you can use the formula:
- Fixed costs / (price - variable costs) = break-even point in units
Impacts of Break-Even Pricing
Facing both positive and negative effects, transacting at break-even prices helps gain market shares and push out competition, while setting an entry barrier for new competitors. However, a low price might create a perception of lower value, obstructing future price increases. During price wars, break-even pricing might not suffice for market control. Theories suggest that due to competition, prices will tend toward break-even, limiting long-term profits.
Real-World Example
Suppose firm ABC manufactures widgets. The total costs per widget include:
| Widget Cost | $ |
|---|---|
| Direct Labor | 5 |
| Materials | 2 |
| Manufacture | 3 |
| Total Cost | 10 |
The break-even price for each widget is $10. If ABC scales and invests $200,000 in fixed costs to produce 10,000 widgets, the break-even price per unit is calculated as:
- (Fixed costs) / (number of units) + price per unit: $200,000 / 10,000 + 10 = $30
For 20,000 widgets, it’s $20 using the same formula.
For an options contract, with a $100 strike price and a $2.50 premium paid, the break-even price would be $102.50. Anything above this level is profit; below, it’s a loss.
Break-Even Prices in Personal Finance
Break-even prices can help individuals manage investments. Selling a house at its break-even price leaves one with no debt and no profit. Investors holding losing stock positions can use strategies to break even. Break-even calculations may differ by industry but follow the same basic premise.
Break-Even in Options Trading
In general, the break-even price for an options contract equals the strike price plus the premium cost. For example, a 20-strike call option costing $2 has a break-even price of $22. For a put option, it would be $18.
Importance of Taxes and Fees in Break-Even Analysis
Gross break-even points can be incomplete. Taxes, fees, and other charges must be accounted for. For instance, a $10 stock profit may incur $1.50 in taxes and a $1 commission, and inflation should also be considered, especially for long-term holdings.
Related Terms: break-even analysis, strike price, gross profit margin, fixed cost, variable cost.
References
- Jean Vercherand. Is a Synthesis of Economic Theories Possible?. In Labour. Palgrave Macmillan, London, 2014, Pages 162-174.
