112 ACCOUNTING FOR MANAGERS
The actual mark-up used may be based on a ratio (see Chapter 7) such as return
on sales (as in the above example), which is likely to be arbitrary or as a target
return on investment.
Target rate of return pricing
Target rate of return pricing estimates the (fixed and working) capital investment
required for the business and the need to generate an adequate return on that
investment to satisfy shareholders.
For example, if the investment required is £1,000,000 and the company wants
a 12% return on investment, the desired profit is £120,000 (£1,000,000 @ 12%).
Assuming a volume of 20,000 units, each unit would need to generate a profit of
£6 (£120,000/20,000 units). If the total cost was £20, the selling price would be £26.
This represents a 30% mark-up on cost and a 23.1% margin on selling price. Target
rate of return pricing is likely to lead to pricing decisions that are more closely
linked to shareholder value than adding an arbitrary margin to total cost.
Optimum selling price...................................
While cost-plus pricing is useful, it ignores the relationship between price and
demand in a competitive business environment. The sensitivity of demand to
changes in price is reflected in theprice elasticity of demand.Elastic demandexists
when a price increase leads to a fall in demand as customers place little value
in the product or switch to substitutes.Inelastic demandexists where small price
increases/decreases cause only a small change in demand because customers
value the product or because no substitute is available.
Theoptimum selling priceis the point at which profit is maximized. To
ascertain the optimum selling price, a business must understand cost behaviour
in terms of variable or fixed and have some ability, via market research, to predict
likely changes in volume as prices increase or decrease.
Using the example earlier in this chapter, XYZ Limited is able to estimate the
likely increase in demand as the selling price falls. For each level of activity we can
calculate the revenue, variable costs and total contribution. The figures are shown
in Table 8.2.
An approach that seeks to maximize sales revenue will result in a strategy that
seeks to sell 25,000 units at £25 each, with total revenue being £625,000. However,
taking account of the price/volume relationship and costs (which were estimated
as £10 variable cost per unit) shows that the business willmaximize its contribution
towards fixed costs and profit at £400,000 with an optimum selling price of £30.
This is even though the number of units sold will be less at 25,000 with total
revenue of £600,000.
The highest contribution will always be the highest profit as the fixed costs
(£200,000) will be unchanged at each level of activity within the relevant range (note