Pricing - return on investment ("ROI") method

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.

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Pricing - return on investment ("ROI") method

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