What it means
A company needs a way to compare opportunities that use scarce capital, so it may set a minimum expected return for a project after considering its financing cost, risk and available alternatives. A higher-risk proposal may require a higher target, though mechanically adding an arbitrary premium is not careful analysis.
Different measures can give different answers, because accounting return on invested capital is not the same as an internal rate of return on future cash flows, so always name the metric before comparing it with a hurdle. A manufacturer can also work backward from a target return to a proposed selling price by estimating investment assigned to a product line, the target percentage, expected sales and unit cost.
If investment is $1 million and the desired annual return is 20%, the annual target profit is $200,000, and at 50,000 units that adds $4 per unit to a defined cost base. The price still has to compete in the market.
Volume is the fragile assumption, since a higher computed price may reduce demand and invalidate the expected unit count used in the formula. A lower price could generate more contribution if volume rises sufficiently, and costs may also change with volume, so fixed costs must be allocated consistently.
Test several price-volume combinations and calculate actual expected profit rather than declaring the target achieved because the spreadsheet shows a required price. A target should reflect risk and timing, because a project with cash receipts many years away cannot be fairly compared with a one-year return percentage without careful treatment.
Inflation and currency effects may matter, and investors may use a nominal or real target, while mixing those bases can distort decisions. Cost of capital is an important benchmark, but tax, strategic benefits and constraints need separate attention, and a target lower than cost of capital is not automatically irrational for a subsidised or strategic project as long as it is explicitly justified.
For performance review, distinguish an aspiration from a forecast. An annual target of 15% does not mean an investment is likely to deliver exactly 15%, and a shortfall can come from demand, cost or execution, so compare realised results with the assumptions made at approval, update the model and avoid moving the goalpost after the fact.
For owners, use the target to make trade-offs visible by stating the return definition, invested capital, period and downside scenario. In pricing, also test customer willingness to pay and substitutes, and in project selection use appropriate cash-flow measures as well as operating metrics.
In practice
Real-world examples.
Example
A maker models a new product price intended to earn a 15% annual accounting return on defined capital.
Example
A company compares a project's expected cash-flow return with a risk-adjusted hurdle.
Example
An investor states a 10% nominal annual target but tests the range of possible outcomes.
Formula
Calculation
Simplified target-return price = Defined unit cost + (Target return rate x Allocated invested capital) / Expected units sold.
Worked example: an invented product has a $40 defined unit cost, $1 million of allocated capital, a 20% annual target and forecast sales of 50,000 units. Desired annual profit is 20% x $1,000,000 = $200,000, which is $200,000 / 50,000 = $4 per forecast unit. The illustrative target price is $40 + $4 = $44, but the actual return depends on units sold, costs and other assumptions. Check whether the defined unit cost already includes fixed allocations to avoid double counting.Case study
Seen in the real world.
This illustrative and entirely fictional example follows Aqua Pure, an invented water-filter maker. It had applied one flat markup to every product, though some lines required much more tooling and inventory. Finance calculated capital employed by line, estimated sales volumes and used a 15% target as a planning test. Two lines appeared below the target.
Management tested whether customers would accept different prices and examined cost reductions before changing the range. In the invented outcome, it repriced one line, improved another and dropped a third after assessing customer demand. Its overall measured return rose from 8% to 14%, still short of the aspiration. The case shows that a target can guide choices without guaranteeing a price, demand or return.
Watch out
Common mistakes.
- Presenting a calculated target price as evidence customers will pay it.
- Comparing returns measured over different periods or accounting and cash bases.
- Setting an aggressive target and hiding the downside assumptions required to reach it.
Questions
People also ask.
What is a target return?
A stated return level sought on a defined investment over a defined period.
Does target-return pricing ensure that result?
No. Sales volume, actual costs and customer response determine realised return.
Is a target return the same as a hurdle rate?
A hurdle is a minimum used to screen projects; a target may also be an aspirational operating or pricing goal.
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