Author: Jim Riley Last updated: Sunday 23 September, 2012
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.