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Rate of return pricing

Rate of return pricing Definition


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.

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