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Target rate of return pricing is a pricing method used almost exclusively by market leaders or monopolists.

**Rate of return pricing**

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 in order to produce and market designer snowflakes, and
they estimate that with 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
per flake. Total annual costs would be $100 million (2 million units at $50
each). Next, management decides they want a 20% return on investment (ROI).
That works out to be $20 million (20% of a $100 million investment). Profit
margin will need to be $10 per flake ($20 million return over 2 million units).
So the price must be set at $60 per designer flake ($50 costs plus $10 profit
margin). Similar calculations will determine price based on rate of return to
sales revenue.

An unusual consequence of this
pricing model is that to keep the target rate of return constant, the firm will
have to continuously be changing its price as the level of demand changes. This
can be seen in the diagram below. Based on market demand expectations, the firm
estimates it will be operating at 70% capacity. Given its production function
and cost structure, it knows its average total costs at that output level will
be represented as point A . If its predetermined rate of return requirement is
amount A, B, then it will set its price at P*. Because profit is equal to
(P-ATC)*Q, then their total profit will be defined by area P*, B, A, P70%.

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