Return on Investment Pricing
Under full-cost pricing, the normal mark-up was based on the total cost. So, obviously, this method of pricing does not recognize capital investment in determining proposed selling price. Yet, the return on capital required to produce, finance and distribute products is widely recognized as crucial index of managerial efficiency. Consequently, management can aid its performance by knowing what selling price would provide a given rate of return on investment.
To illustrate how this practical approach to the determination of the normal mark-up on price as a certain rate of Return On Investment (ROI), let us consider the previous illustration dealt in the full-cost pricing method. Assume the company brings in a capital of Rs.20 lakh and the cost of raising its capital is 15%. The calculation of proposed price would be as follows:
|
Particulars
|
Total
|
Per Unit
|
|
Rs.
|
Rs.
|
|
Total costs of make and sell
|
12,00,000
|
24.00
|
|
Mark-up (15% × 20,00,000)
|
3,00,000
|
6.00
|
|
Proposed selling price
|
15,00,000
|
30.00
|
Even this method does not speak about the allocation or apportionment of fixed cost, but the advantage that ROI pricing has over cost-plus pricing is that the mark-up for net income has a definite methodology. Besides that, this method furnishes an excellent analytical tool for appraising alternative selling prices. Not only does it guide management in determining what selling price will provide a given rate of return, but it may be used to show what rate of return a given price will bring.
Illustration
A company has furnished the following cost data:
|
|
Per Unit
|
|
Direct material
|
Rs.7.50
|
|
Direct wages
|
Rs.6.00
|
|
Variable overheads
|
Rs.1.50
|
|
Fixed factory overheads
|
Rs.13,00,000 p.a.
|
|
Fixed selling and administration overhead
|
Rs.7,50,000 p.a.
|
|
Capital employed on fixed assets
|
Rs.20,00,000
|
|
Annual sales
|
8,00,000 units
|
Capital employed in current assets are 50% of sales. Determine the selling price per unit to yield 20% return on capital employed.
Solution
Let the selling price per unit be x
|
Capital employed
|
=
|
Fixed assets + Current assets
|
|
|
=
|
Rs. 20,00,000 + 50% of 8,00,000x
|
|
|
=
|
Rs. 20,00,000 + 4,00,000x
|
|
Profit
|
=
|
20% on capital employed
|
|
|
=
|
20% (Rs. 20,00,000 + 4,00,000x)
|
|
|
=
|
Rs. 4,00,000 + 80,000x
|
|
Cost
|
=
|
Variable Cost + Fixed Cost
|
|
|
=
|
15 × Rs.8,00,000 + Rs.20,50,000
|
|
|
=
|
Rs. 1,20,00,000 + Rs.20,50,000
|
|
|
=
|
Rs. 1,40,50,000
|
|
Sales
|
=
|
Cost + Profit
|
|
8,00,000x
|
=
|
Rs.1,40,50,000 + Rs. 4,00,000 + 80,000x
|
|
7,20,000x
|
=
|
Rs.1,44,50,000
|
|
x
|
=
|
Rs.1,44,50,000/7,20,000
|
|
|
=
|
Rs. 20.06 or Rs. 20
|
|
Selling price per unit
|
=
|
Rs. 20
|
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