Rate of Return
Pricing
Start with a rate of return objective, like
5% of invested capital, or 10% of sales revenue. Then you arrange your
price structure so as to achieve these target rates of return. Target
rate of return pricing is a pricing method used almost exclusively by
market leaders or monopolists.
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 (ATC) 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).
That works out to be $20 million (20% of a $100 million investment).
Profit margin will need to be $10 dollars per flake ($20 million return
over 2 million units). So the price must be set at $60 per designer
flake ($50 costs plus $10 profit margin). Similar calculations will
determine price based on rate of return to sales revenue.
An unusual consequence
of this pricing model is that to keep the target rate of return constant,
the firm will have to continuously be changing its price as the level
of demand changes. This can be seen in the diagram below. Based on market
demand expectations, the firm estimates it will be operating at 70%
capacity.
Given its production function
and cost structure, it knows its average total costs at that output
level will be represented as point A . If its predetermined rate of
return requirement is amount A, B, then it will set its price at P*.
Because profit is equal to (P-ATC)*Q, then their total profit will be
defined by area P*, B, A, P70%.
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