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.
http://tutor2u.net/business/marketing/pricing_roi.asp
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