Breakeven Analysis Is A Product Manger’s Secret Weapon

by drjim on September 14, 2009

Breakeven Analysis Is How Product Mangers Defend Their Pricing

Breakeven Analysis Is How Product Mangers Defend Their Pricing

Product managers know that how they price their products can be the difference between runaway success and total failure for their products. However, knowing this and knowing how to price well are two completely different things. In fact, there is often a great deal of outside pressure on product mangers to change their product’s price all the time. When should a product manger do this, and when should they not?

An Introduction To Breakeven Analysis

It turns out that numbers are on the side of a product manager when it comes to pricing. Assuming that you’ve done your homework and you’ve come up with what you believe to be a fair price, then you’ve got a good place to start from.

Almost without fail, folks on the sales team will show up and tell you that you’ve priced your product too high – they’ll never be able to sell it at its current price. This is where break-even analysis comes in.

The trick is that any discussion about your product’s pricing can’t just be about the price. Instead, it needs to also include a discussion of how many units will be sold at a given price. You got it – what we’re really talking about here is profit. Your company doesn’t really care if you sell a million copies of your product at $1 each or just one copy for $1M. What they care about is the amount of profit that they’ll make from selling your product.

Break-even analysis gives you the tools that you need to figure out how your product’s price and the quantity of products that need to be sold are related.

How To Use Breakeven Analysis

What break-even analysis is going to allow you to do is to calculate the minimum number of sales that your sales team is going to have to make in order to make up for any lowering of your price (or fewer sales if you are going to raise the price).

Here’s the formula:

Breakeven analysis formulaThe formula uses the amount that you want to change your product’s price by (in $) and divides it by your current margin (CM – how much profit you currently make on each sale) added to the price change once again. Note that the price change has a sign – negative if you are lowering your price, positive if you are raising it.

If you’d like to hear me explain this in greater detail along with some additional examples, it’s all online at Product Pricing: Cost Plus is Wrong, So What’s Right?

Final Thoughts

As product managers we are ultimately responsible for the success of our products. How we choose to price our products plays a big role in their long term success. Nobody will ever be happy with our pricing and we’ll always be asked to make changes to it.

Breakeven analysis is a tool that product mangers can use to expand the pricing discussion to include sales quantity. This turns the entire discussion into a profit discussion and that’s the type of conversation that product mangers should be having. Product managers who can do this will have have found yet another way that great product managers make their product(s) fantastically successful.

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What We’ll Be Talking About Next Time

So what do product mangers mange? Generally I’d agree with you if you answered “products“; however, I’ve been giving this some thought and I think that we’re missing the mark if that’s our answer.

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{ 6 comments… read them below or add one }

Robin Zaragoza September 29, 2009 at 1:46 pm

Jim – how do you apply this when you’re talking about software and there are economies of scale with each new sale? Specifically, your current margin would always be changing. Maybe define CM as the average for the previous month to nail it down temporarily, but keep adjusting it over time?

Reply

Dr. Jim Anderson October 3, 2009 at 10:05 am

Robin: good question. However, software (and other digital products) really don’t have the economies of scale that you mention. The reason is that your cost of production (variable costs) doesn’t go down the more you sell — digital products (pretty much) have a one-time cost to create them and then all additional expenses are just overhead (shipping, etc.).

Instead you need to view your software development costs as fixed costs. Your variable costs are going to be minimum for each unit sold (really minimum if it can be downloaded — no shipping!). This means that you’ll have a huge profit margin. Great news. However, remember that the software biz has huge fixed costs also that need to be paid for — but this is not to be included in your pricing.

Hope this helps.

Reply

Ajith January 3, 2011 at 9:38 am

@Dr. Jim, very interesting comment on the software industry.

Could you specify why the Fixed costs of developing the software are not to be included in the PM’s arena for pricing?

Cheers
AJ

Reply

Dr. Jim Anderson January 7, 2011 at 3:25 pm

Ajith: Not sure if I fully understand your question (this article talked about changing your product’s price, not fixed / variable costs). However, let me take a try at answering what I think that you are asking. A fixed cost is a cost that does not change based on how many copies of your product you make — such as if you buy a machine to stamp metal. Once you’ve made this purchase, it’s done — no matter how many copies of your product you make / sell, you can’t change this cost. Product managers need to focus on boosting their product’s margin (and total amount of profit made). They don’t spend much time worrying about fixed costs because simply there is nothing that they can do about it after the purchase has been made.

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Ajith Nair January 10, 2011 at 10:36 pm

Hello Jim!

Many thanks for your reply!

You are right in classifying the Programming of the software as a fixed cost. And you are also spot on about PM’s having to focus on increasing their Product Margin.
However, it can so happen that they would need to consider the fixed costs involved in let’s say Localizing a product. For example, if the product managers of Corel think that localizing Corel Draw in Arabic can provide X amount of sales and Y % margin, they would then find it interesting to invest in hiring translators to do the job.

Also, for including another vendor’s software with every copy of their own software, as a value added pack, could sometimes be a fixed cost (thought it is mostly variable) which they might need to consider.

Reply

Dr. Jim Anderson January 14, 2011 at 11:23 am

Ajith: You make several very good points. One thing to note in your examples is that, for example, once you’ve translated a product, that cost can never be recovered. Therefore, it really should play a minimal role in your pricing! The decision to spend the money to do the work needs to be based on how successful you think that the product is going to be. If your profits will cover your expenses, then go for it!

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