Profit-oriented pricing objectives help the firm achieve some desired level of profitability. Generally, profit-oriented objectives take two forms: (1) pricing to achieve a desired target return; and, (3) pricing to achieve profit maximization.
Target return pricing objectives set a specific level of return on investment or return on sales as the pricing goal. Generally, the objective is specified as a percentage return. For example, a manufacturer of farm and construction equipment, such as John Deere, may specify a 15% or 20% return on investment (ROI). ROI is measured as the ratio between the firm's net profit and its investment in the plant and equipment required to generate that profit. The calculation of ROI is illustrated in Exhibits 1 and 2. Assume a manufacturer has $276,000 invested in the manufacturing process for a new product. If the manufacturer's sales of the new product are $100,000 from which $47,000 cost of goods sold and $24,000 in operating expenses are subtracted, a net profit (before taxes) of $29,000 results (Exhibit 1). The ratio between the $29,000 profit figure and the initial $276,000 investment is the firm's ROI (Exhibit 2).
Large manufacturers, particularly industry leaders, commonly employ ROI pricing objectives because of their relatively high investment costs and their ability to somewhat control the prices for products in their respective industries. In contrast, a wholesale grocery supplier, such as Fleming Wholesalers, may specify a 10% return on sales (ROS) as its pricing goal. ROS pricing objectives are more typical of middlemen (wholesalers and retailers).
Target return objectives such as these are particularly popular for manufacturers because they are easily measurable -- firms can easily determine whether the pricing objectives have been met.
The most commonly employed pricing objective is probably one of profit maximization in which price is set to maximize profits. Usually, this pricing objective is applied to single products, but it can also apply for entire product lines. For example, Gillette may price its razors fairly low to stimulate demand, but the prices for replacement razor blades are relatively high. Prices for the razors and replacement blades may be specifically set to maximize profits across both complementary products taken together.
Profit maximization pricing objectives are typically employed for new products, prestige products, and products for which high quality standards are important. In these situations, price usually is set relatively high to appeal to innovators and early adopters. However, high prices are not necessarily those which will maximize profits. When demand for goods and services is price-elastic, lower prices will stimulate added demand, thereby increasing total revenue. It is therefore possible that, when demand is highly elastic, lower prices may yield higher profits. For a theoretical economic perspective, profits are maximized at the level of unit sales where the revenue generated from the next unit sold (marginal revenue) equals the total costs of producing that unit (marginal costs). Thus, careful attention must be paid to price and demand relationships when searching for the profit-maximizing price.
Page last modified: January 19, 2001