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What Is Target Return Pricing?

By Priceva
on December 20, 2022
In this article, we will consider the concept of target profitability, as well as the pricing that meets this goal. We will highlight the pros, cons, and useful strategies. The main idea of target return pricing is to correctly select the prices of goods in order to satisfy the requirements of investors. Read further to find out more details about this strategy.

Understanding Target Return Pricing

Target return pricing is a method of calculating the cost of a product, in which the company must achieve a certain profitability in a certain time. The company needs to achieve some goal in order to satisfy the profitability of the investor.

Imagine the following situation: an investor gives you money to develop your brand and sets a time frame. Suppose the investor wants their investment to grow by 50% in two years. That is, after two years, this person or organization wants to get back the initially invested amount plus 50%. You are then faced with the task: how to increase the investor's capital by 1.5x in two years? To achieve this goal, it’s extremely important to set the right pricing for your products or services.

The target return strategy can also be used to reach your own goals. If you yourself expect, for example, to receive a certain level of profitability by the end of the year, you need to calculate the right prices.

How Do You Price a Product to Sell?

One of the first steps when it comes to developing a new product or service is deciding on the price. As you already know, the price can be a very fluctuating factor, and it will depend on many parameters. But, when a company says that they want to set the right pricing strategy, what they actually mean is that they are on the hunt for a price that sells. The logical question is: how to find it?

First of all, you need to consider your production costs, which include the cost of production itself , as well as promoting the product. For example, say it costs you $10 to produce a product and $5 to advertise it. Conclusion: You cannot charge less than $15 for this product. How much more is up to you.

Many different factors can come into play here, but the most basic ones are investor expectations and purchasing power. Moreover, purchasing power and demand may change over time. Will customers have the desire and the money to buy your product? Everything will be individual here, depending on what you sell, what your market is, what your target audience is, and so on.

Examples of Target Return

Let's say investors gave some Chocolate Producer $1 million for production and promotion, with the condition that this amount increase by 10%.

If one chocolate bar costs $2 to produce, and the Chocolate Producer expects to sell 50,000 of them, then the price must be high enough so the company is confident that it can increase the investment by 10%, that is, by $100,000. In addition, they need to take into account the time frame.

If the company cannot sell all 50,000 chocolates in that time, then it will need to increase the price even more and rethink its pricing strategy.

How to Calculate the Target Rate of Return

When you calculate the cost, you will need to consider all possible scenarios. Ideally, you will have to recoup all production costs and earn the required interest for investors.

Come up with a price that gives you the target return on investment. Then, calculate the product of the desired rate of return plus your capital investment to get the total return. See the formula below:

Target-Return Pricing = Unit Cost + (Desired Return x Invested Capital) / Unit Sales

Remember that the return must equal the money invested in the venture + profit that the investors want to see in return (adjust this for the time value of money).

Advantages and Disadvantages of Target Pricing

Target Pricing is an effective tool, but it has its pros and cons.

Advantages

  • This approach will help to increase the efficiency of the company and bring more profit.
  • You will be able to estimate the cost of the product without taking into account further price increases.
  • This strategy will allow you to achieve progress faster and within a specific timeframe.
  • You will be able to make forecasts and better understand how much the buyer is willing to pay for the product.

Disadvantages

  • You need to carefully study your market, because any mistakes will greatly affect your company.
  • There may be pressure on the production departments to reduce costs, which will lead to a decrease in the quality of the product. This definitely cannot be allowed.

Conclusion

In summary, target return pricing can be an effective tool if you carefully study the market and are able to make correct forecasts. And in order to make successful forecasts, you need to know your customers well.

The pricing process is always a difficult task, and Priceva's Retail Price Optimization can help you with it. The recommendations of this service are based on the elasticity of demand. Price optimization will allow you to solve several problems at once. And of course, all information is based on real facts.

A few key takeaways from this article:

  1. With target pricing, the financial goal and timing are clearly defined.
  2. The strategy can change if something doesn't go according to plan.
  3. When predicting sales and customer behavior, you need to know your market well.
  4. Your target return price should be equal to the profit that an investor expects from their investment.
  5. Target pricing places a strong emphasis on the time value of money.
  6. Investors must work backwards from the expected return to reach the typical current price.
  7. This strategy differs from cost-plus pricing, as the latter simply takes manufacturing costs and adds a markup.
  8. The application of all these rules and strategies will allow the company to get more profit, since you will return the money to investors and earn interest yourself.
The target return pricing strategy is an advanced strategy that many e-commerce stores only think about using once they’ve matured and have received external support in the form of investment.

FAQ

What is the purpose of target return pricing?

The goal is determined either by the investor or by the owner of the company. The approach itself is important to achieve this goal effectively: you must create a clear plan, study the market, and analyze what customers are willing to buy, and at what price.

How do you use target pricing?

Determine the goal and make several calculations: production costs, the minimum cost of the product, promotion costs, and so on. Research the market and determine the price. If you create the right price, you will achieve your goals.

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