pricing - return on investment method
The "return on investment" pricing method determines the price of a product based on the target return on the amount invested in a product:
The calculation is as follows:
|
Unit Price |
Total costs (fixed and variable) + (% return x Investment) |
|
Budgeted sales volume |
This calculation can be illustrated using the following example:
Willowbrook Limited has developed a new product called the "Eternal Flame" - a methane-powered heater for use in industrial buildings. Willowbrook requires a return on invested capital of 25% per annum. The sales price for the Eternal Flame should be set using a target return on investment method. The following additional information has been provided:
| Budgeted sales volume |
25,000 units |
| Variable production cost per unit |
£45 |
| Fixed production cost per unit |
£25 |
| Other annual fixed costs (overheads etc.) |
£550,000 |
| Investment in new machinery to produce the Eternal Flame |
£350,000 |
| Period over which investment in new machinery to be written off |
4 years |
| Research and development costs for the Eternal Flame |
£225,000 |
| The total investment in the Eternal Flame is (New machinery + R&D costs) |
£575,000 |
| The required annual profit = £575,000 x 25% |
£143,750 |
| Total annual costs can be calculated as follows: |
|
| Production costs per unit (£45 + £25) x 25,000 units |
£1,750,000 |
| Annual depreciation on new machinery (£350,000 / 4) |
£87,500 |
| Other annual fixed costs |
£550,000 |
| Total annual costs |
£2,387,500 |
| Total required annual revenue = total annual costs + required annual profit |
£2,531,250 |
| Unit price (total required revenue / budgeted sales volume |
£101.25 |
The use of a targeted return on investment to determine price has the following advantages:
- Consistent with other performance measures - e.g. Return on Investment
- A suitable method for market leaders which are able to set a price which competitors follow
- A relevant pricing method for new products - particularly those which have a substantial investment.
The method does, however, have some disadvantages:
- With new products, there is an inherent uncertainty about what the achieved sales volume will be - which in turn will be influenced by the price chosen
- Some investment may be common to several products or product groups (e.g. an extension to a factory; investment in new development facilities). This raises the question of how to apportion investment amongst products.
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