What Is Target Return?
A target return is a pricing model that prices a business based on what an investor would want to make from any capital invested in that company.
- A target return refers to the future value, or profit, that an investor expects from their investment.
- Target return is different from other pricing models because it takes into account the time-value of money.
- Typically, investors work backward from the expected target return to reach a current price.
- Target return is different from the cost-plus-pricing model in which a product's manufacturing costs are added up and a markup is added.
Understanding Target Return
Target return is calculated as the money invested in a venture, plus the profit that the investor wants to see in return, adjusted for the time value of money (TVM). As a return-on-investment (ROI) method, target return pricing requires an investor to work backward to reach a current price.
One of the major difficulties in using this pricing method is that an investor must pick both a return that can be reasonably attained, as well as a time period in which the target return can be reached. Picking a high return and a short time period means that the venture has to be much more profitable in the short-run than if the investor expected a lower return over the same period, or the same return over a longer period.
Target return can also be used to project the price a company should set on its product sales to generate a desired profit. This model presumes that the company will be able to achieve the projected sales volume in order to reach the target return. If actual sales come up short, the pricing would have to be adjusted in order to achieve the target.
For instance, a flashlight company might set a target return of 15% on $10 million that was invested into the development of a new flashlight. The manufacturing cost per unit is $12, and the company expects to sell at least 70,000 units within the specified timeframe. That means each new flashlight would need to be priced at $33.43 and up to deliver the sought return.
The target return model differs somewhat from a cost-plus pricing strategy, wherein the price markup is based on other criteria. The cost of producing the product is the main factor, with an additional profit margin created by setting the price higher. Time and expected volume of sales do not play a part in this price model. Instead, the company determines how much it wants to earn from the product it sells, without consideration of any investments into the company or the development of the product.
Another model, value-based pricing, works from the opposite direction. This starts with the value the company assigns to the product and then works to adjust the costs of production to achieve profitability.