Pricing to Achieve Target Profits

The assumption made in simple economics theory is that in a situation of imperfect competition companies will be 'profit maximizers', that is, they will aim to make the highest profit the situation allows. A simple approach to achieving this is to charge 'what the market will bear' — the highest price that customers are prepared to pay (although once again we have the difficulty that in many situations price will affect the quantity sold). In practice, however, most companies seem rather to aim at a satisfactory level of profit — in economics language they are 'satisficers'. What is a satisfactory level of profit?

Clearly it is not enough to aim purely at the greatest amount of total profit, regardless of all other considerations. For example, suppose a business with $10,000 invested in it earns profits of $2,000. Then suppose that profits could be increased by a further $200 per annum but only by using further capital of $10,000. Clearly, this would not be a good use of the additional $10,000 which would earn more in the bank.

We have to look then at maximization of the percentage of profit in relation to the capital used in the business (usually referred to as 'return on capital employed'). There is a slight complication, since capital employed can be calculated in a number of different ways, but only the principle need concern us here.

A company can set as its objective a return of 10 per cent, 20 per cent or whatever on the capital employed in the business. The break-even approach can be used to establish whether a given project is likely to achieve this result and, if not, the project will not be taken up.