Academic journal article Management Accounting Quarterly

Estimating Retail Breakeven Using Markup Pricing

Academic journal article Management Accounting Quarterly

Estimating Retail Breakeven Using Markup Pricing

Article excerpt

An inexperienced entrepreneur planning the start of a small retail business often must rely on extraordinarily broad, imprecise assumptions and estimates when forecasting what it will take for the business to become profitable. There are many unknowns in this situation that are potentially dangerous. Yet every year, thousands of people launch into the deep waters of starting a retail business, perhaps blissfully unaware of some of the hazards.

Cost-volume-profit (CVP) analysis can be a good starting point in forecasting if the decision maker does not rely on faulty assumptions. In retail operations, the cost of goods sold (COGS) is one traditional way to estimate the breakeven point. But for the first-time entrepreneur who expects to sell scores or hundreds of different products, each one with a different cost of goods sold, it is impractical to try such analysis before operations begin. When the COGS is unknown in advance, only large, round numbers can be used for estimating. Many new owners of retail businesses have neither the luxury nor the knowledge to achieve precise estimates before they rent space and order inventory.

In these situations, markup pricing may be useful. Markup pricing involves adding a percentage to the cost of a product to arrive at a selling price. Also known as costplus pricing, markup pricing is a straightforward way to determine product prices. It could appear to make breakeven analysis unnecessary, for example, by assuming that competitors are marking up a certain product category by a particular percentage and still can be in business. Alternately, dividing products into 10 to 12 different categories, each with a related markup percent, can provide a better estimate of breakeven.

A CVP formula based on markup pricing can provide a practical solution for first-time retail entrepreneurs if information is available on the markup percentage for each product category and the estimated proportion of sales per category. Although it has drawbacks, the biggest advantage of markup pricing based on cost is that it simplifies decision making. For example, a 40% markup for a particular product line, even if there are many different products in the line, can be applied quickly without the need to consider the price on an item-by-item basis. Using markup pricing also may be seen as a way to prevent a price war if the entrepreneur believes that competitors use the same markup percentage. Another benefit of markup pricing based on cost is that it overcomes the inherent uncertainty that a first-timer would face in setting prices because the retailer may not be able to accurately predict future changes in costs or future sources of costs.

Though pricing based on cost is a handy, time-saving shortcut, it also has a downside. It takes an accounting point of view of profit, ignoring the opportunity costs associated with selecting one product line over another or selecting one type of business over another. Applying a markup percent may also lead to a false sense of confidence that the prices will lead to profitability: If that percent is chosen arbitrarily without the user thoroughly understanding the breakeven dynamics of the business, it can have the opposite effect and undermine profitability. The profitability of an entire industry can be impacted if retailers follow each other down this path. Finally, markup is a gross estimate, and gross estimates introduce uncertainty. When used in forecasting where uncertainty already exists, adding more uncertainty is far from ideal.

UNKNOWNS FOR FIRST-TIME ENTREPRENEURS

Pricing decisions typically are more complicated than simply marking up the wholesale cost of a product or product line. Retailers must think in terms of the overall perceived value being offered (value pricing) instead of individual prices or even product line markups or margins. That requires considering more than one piece of information, including competitor pricing on products that are anchors for customers' perception of overall pricing, consumer perception of value, and an understanding of which products most likely will drive customer traffic and which products are vital to the perception of assortment and quality. …

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