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The amount of revenue a business earns for a particular product depends on how much they charge for it— that’s obvious. For most small business owners, how to determine the most profitable price point isn’t quite so obvious.

Different types of costs affect your profit margins in different ways. Some costs increase or decrease depending on how many units of a product are produced, while others remain constant regardless of activity levels.

To analyze costs more effectively, cost accounting first requires you to separate them into two categories: fixed costs and variable costs. Fixed cost and variable cost estimates are the two most important pieces of this analysis, so it’s important to make sure the numbers you’re working with are accurate.

Fixed Costs

An accurate estimate for fixed costs will include any facility rent and insurance premiums, and factory overhead expenses. Fixed costs remain constant, regardless of how many units are produced during the period. Factory depreciation, administrative salaries, and operating licenses would normally be included in a fixed cost estimate.

Variable costs

Variable costs, on the other hand, are dependent on sales volume. Purchases, direct materials, direct labor , and packaging costs would be considered variable costs. When production increases, variable costs will increase along with it. As a general rule, costs that change from month to month are usually considered variable costs.

Contribution Margin

Once you have an accurate estimate of the variable and fixed costs associated with a product, you can calculate your contribution margin. A contribution margin is essentially how much of each sale the company can use to cover its fixed costs. For example, if a product is priced to sell at $10 per unit, with variable costs of $6 per unit, the unit contribution margin would be the difference, which is $4 per unit.

Once you know your unit contribution margin, you can figure out how many units of a product you must sell in order to break-even. By dividing the total fixed costs (we’ll say that’s $100,000) by the unit contribution margin ($4), the answer tells us that we have to sell 25,000 units to break-even. In other words, we won’t see a profit until we sell unit #25,001.

Selecting the Most Profitable Price Point

So how can these calculations be used to refine your price points? Continuing with the example above, let’s say that you only have the capacity to produce 24,000 units in your facility. But based on the break-even analysis of the $10 sales price, we will have to sell 25,000 —which is 1,000 more units than we can produce. So clearly, the $10 price point isn’t going to work in this case.

Let’s see what the numbers look like when we sell our product for $11. After subtracting our variable costs of $6 per unit, our new unit contribution margin is $5 per unit. Once we divide our fixed costs of $100,000 by the $5 unit contribution margin, we see we only need to sell 20,000 units to break-even now instead of 25,000.

In this example, increasing our sales price up from $10 to $11 will allow us to recoup our costs faster, so we can start making a profit sooner.