Rate of Return Pricing

Rate of return pricing involves setting prices for a range of products so that they achieve a predetermined rate of return or return on capital employed (ROCE). This pricing strategy aligns pricing decisions with the financial objectives of earning a specific return, ensuring that the company meets its profitability targets.
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What is Rate of Return Pricing?

Rate of return pricing is a method used by companies to set the prices of their products or services. The goal is to ensure that the pricing strategy meets a target return, typically a specified percentage of the investment or capital employed in producing the goods or services. This approach integrates the desired profitability into the pricing structure, focusing on meeting financial benchmarks.

Key Components

  • Predetermined Rate of Return: The specific percentage rate that the company aims to achieve from the investment.
  • Return on Capital Employed (ROCE): A financial ratio that measures a company’s profitability and the efficiency of capital utilization.

Formula for Rate of Return Pricing

1Price = [(Total Costs + Desired Return) / Number of Units] + Variable Costs Per Unit

Examples of Rate of Return Pricing

  1. Manufacturing Company:

    • A manufacturing company calculates the total cost of producing a new product, including the capital invested and the desired return (10%). The company will incorporate this return into the final price to ensure meeting financial goals.

  2. Service Sector:

    • A consultancy firm invests in developing a series of workshops. It aims for a 15% return on capital employed. The firm sets the price for each workshop based on covering costs and achieving the targeted profit margin.

Frequently Asked Questions

Q1: Why is rate of return pricing important?

  • A: It ensures that a company meets its financial targets and profitability objectives by incorporating desired returns into the pricing strategy.

Q2: How does rate of return pricing differ from cost-plus pricing?

  • A: Cost-plus pricing adds a fixed markup to the cost, while rate of return pricing specifically targets a desired financial return ensuring that the investment yields the anticipated profit.

Q3: What are the risks of rate of return pricing?

  • A: Market fluctuations and demand uncertainty can impact the ability to achieve the targeted return. Price sensitivity of customers and competitive pressure may also pose risks.

Q4: Can rate of return pricing be used in competitive markets?

  • A: Yes, but it requires careful analysis of market dynamics and competitive pricing strategies to ensure balance between achieving a target return and maintaining market competitiveness.
  • Required Rate of Return: The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.
  • Return on Capital Employed (ROCE): A measure of a company’s profitability and how efficiently its capital is used. It is calculated as Earnings before Interest and Taxes (EBIT) divided by Capital Employed.

Online Resources for Further Reading

  1. Investopedia on Rate of Return Pricing
  2. Corporate Finance Institute: Rate of Return

Suggested Books for Further Studies

  1. “Pricing Strategies: A Marketing Approach” by Robert M. Schindler
  2. “Managerial Accounting: Creating Value in a Dynamic Business Environment” by Ronald W. Hilton
  3. “Principles of Managerial Finance” by Lawrence J. Gitman and Chad J. Zutter

Accounting Basics: Rate of Return Pricing Fundamentals Quiz

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