Rate of return pricing
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Target rate of return pricing is a pricing method used almost exclusively by market leaders or monopolists. You 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.
For example, assume a firm invests 100 million euro in order to produce and market designer snowflakes, and they estimate that with European 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 euro per flake. Total annual costs would be 100 million euro (2 million units at 50 euro each). Next, management decides they want a 20% return on investment (ROI). That works out to be 20 million euro (20% of a 100 million euro investment). Profit margin will need to be 10 euro per flake (20 million euro return over 2 million units). So the price must be set at 60 euro per designer flake (50 euro costs plus 10 euro 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 it’s production function and cost structure, it knows its average total costs at that output level will be represented as point A . If it’s 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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Rate of Return Pricing with Changes in Demand
If demand increases such that the firm is now operating at 90% capacity and facing a reduced average total cost of C, then margin will increase to C,D and profit will be P*,D,C,P90%. If demand were to decrease so the firm was operating at 40% capacity, margins would be reduced to E,F and the firm would have to increase prices to maintain their desired margin. This is a questionable decision. It is seldom a good strategy to increase prices in the face of falling demand. The net result is usually further reductions in demand. That explains why this strategy is used only by market leaders and monopolists.