Rate of Return Pricing
The rate of return pricing is a method that is applied in pricing used exclusively by larger companies that are regarded as market leaders or monopolies. This approach is exercised by businesses that set specific goals for the investment that they make and the revenue that they intend to generate from it. It is possible that a business can set prices to ensure that is able to achieve these goals. In fact, the concept that is applied here is the same as the concept of return on investment. However, the difference is that in rate of return capital, the owner of the business can manipulate prices in order to achieve this goal.
The most ideal time when a company can achieve result with this method of pricing is that time when the business lacks or has little competition in the market. That is why it is mainly reserved for monopolies and market leaders. To such businesses, the actions of the competitors will have no impact on the rate of return.
Just in the same way that investors are upbeat about generating certain amounts of return on their investments, so do businesses too have profound goals for their income from the sale of goods and services. Both have to keenly look into the risk that is involved with the capital that they spend. Since the similarities are obvious, most business owners take an approach that is investment-styled in order to determine the cost of their goods through practicing the concept of rate of return pricing.
As an illustration of how the rate of return pricing is conducted, imagine that a particular company is expecting a rate of return of 20% for the goods that they have on sale. The first part of 10 products cost the company $1,000 in terms of manufacturing costs. For the company to be able to hit their target of 20% rate of return, they must price every product for a price of $120. If this is done, all the products will be able to earn the company a profit of $200, which is exactly 20% of the initial cost of manufacturing that was valued at $1,000.
The assumption of the rate of return pricing model is that the company does not have any competition in the market. In case there was competition, there are chances that one or even more of the other companies that also deal in the same product can sell at reduced prices.
Despite the existence of competition in the market, a company still has the option of adjusting prices using a rate of return pricing method. Companies have to first know the amount of profits that they require in order to sustain the business over an extended period of time, especially in the preliminary stages of starting a business when costs are relatively high. It is advisable to set an expected rate of return for proper business management.
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