Finance:Rate of return pricing

Rate of return pricing or Target-return pricing is a method of which a firm will set the price of its product based on their desired returns on said product. The concept of rate return pricing is very similar to return on investment however, in this circumstance the company can manipulate its prices to achieve the desired goal. This method is used primarily by companies that either have a lot of capital or have a monopoly on the market and when an investor requests a specific return on their investment. In a competitive market rate of return pricing can be a poor market strategy as its focus at the final profit margins and does not account for supply and demand factors. If a competitor is able to set a lower price, it could decrease demand for the product resulting in a lower sales then forecasted and failing to reach the desired profit margin.

Formula

The formula is: Target-return pricing = unit cost + [(desired return on investment * invested capital) / expected unit sales]

For example, assume a firm invests $100 million in order to produce and market designer snowflakes, and they estimate that with demand for designer snowflakes being what it is, they can sell 2 million flakes per year. Further, from preliminary production data they know that at that level of output their average total cost is $50 per flake. Total annual costs would be $100 million (2 million units at $50 each). Next, management decides they want a 20% return on investment (ROI) which is $20 million (20% of a $100 million investment).

Enter this data into the formula:

Target-return pricing = 50 + [(0.2 *100 million) / 2 million]

Target-return pricing = 50 + (20 million / 2 million)

Target-return pricing = 50 + 10

Target-return pricing = 60

Thus the price for the snowflakes will be $60 each.

Advantages

Rate of return pricing enables firms to better assess the profitability of a product or service. It enables the cost of invested capital to be accounted when the setting price per unit and can be used to forecast the end monetary return of an exercise. It also helps the company in reaching certain profit goals' while maintaining liquidity. Additionally, if market conditions are stable, forecasts for returns will be extremely accurate as a certain target is being used in pricing achievements are solely dependent on sales.

Disadvantages

There are some disadvantages with this pricing method as due to its simple formula many real world factors are omitted hence, it only works within certain requirements. The market in which the company operates in must have high price elasticity with demand staying the same when prices increase the company must also either have a monopoly on the market or very little competition in the market. If there is high competition within the market than a competitor with a like-for-like product will be able to adjust their prices to shift market share towards their product. This will result in a decrease in sales and ultimately falling short of initial targets.

Another disadvantage there is no price buffer to allow for changes in market conditions and the impacts these may have on the cost of any product. As if demand decreases than operational costs will increase per unit produced. As unit cost increases so does the target-return price created a less desirable product. the biggest of the disadvantages is based on the assumption of how many units they are going to sell. Because a company can only estimate at the amount of units they are going to sell, it is not always going to be accurate. If they fall short of their estimates than they are guaranteed to not meet their desired ROI.

Ultimately supply and demand, customer preference, market events and competitor pricing strategies are externalities which are overlooked by rate of return pricing.