What Is Rate of Return Pricing?
Rate of return pricing is practiced by businesses that set specific goals for the capital that they spend and the revenue they wish to generate. A business can set prices to ensure that these goals will be achieved. The concept of rate of return pricing is similar to the investment concept of return on investment, except that the business owner can manipulate prices to help achieve this goal. This method of pricing is most effectively achieved when a company has little or no competition in the market, since the actions of competitors will likely affect the rate of return.
Just as investors wish to generate a certain amount of return on their investment, so to do businesses have ideal goals in mind for their income on the sale of goods and services. Both investors and businesses alike have to be concerned with the amount of risk involved with the capital they spend. Since the similarities are so obvious, many business owners take an investment-styled approach to how much their goods cost by practicing rate of return pricing.
As an example of how rate of return pricing works, imagine that a certain company has in mind a rate of return of 20 percent for the goods that they sell. Their first batch of 10 products cost them $1,000 US Dollars (USD) to manufacture. In order to reach their specified goal of a 20 percent rate of return, they must price each product at $120 USD each. By doing that, selling all 10 products will earn them a $200 USD profit, which is 20 percent of their initial $1,000 USD cost.
Of course, this example of rate of return pricing assumes that the company has no competition from other businesses peddling the same product. If there were competition, one of the other companies might sell the same product for a lower price. In that case the original business would have to react with lower prices itself or run the risk of selling none of its products.
Even if there is some competition, a company can still adjust prices using a rate of return pricing method. Company owners have to be aware of how much profits they need to sustain the business over a period of time, especially in the early stages of a business when costs might be higher. As a result, setting an expected rate of return is a good way for business management to keep a lid on extraneous costs and attempt to be as efficient as possible with the goods they sell.
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