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# Average Rate of Return Method/Accounting Rate of Return Method:

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1. Define and explain the average rate of return method.
2. How is average rate of return calculated?
3. What are its advantages and disadvantages?

Contents:

## Definition:

Average rate of return is a method of evaluating capital investment proposals that measures the expected profitability of an investment in plant assets. This method is also known as accounting rate of return method. Average rate of return method is one of the methods of evaluating capital investment proposals that does not consider present values.

## Formula:

Following formula is used to calculate average rate of return:

 Average rate of return = Average annual incremental income / Average investment

The numerator (average annual incremental income) and denominator (average investment) in the above formula are now explained below:

### Average Annual Incremental Income:

The expected average incremental income to be earned is equal to the sum of incremental income over the project life divided by the project life. The annual incremental income can be calculated for revenue enhancing projects or cost reduction projects. When this formula is used for revenue enhancing projects, the annual incremental income is calculated using the following equation:

Incremental income = Incremental revenue - Incremental cost including depreciation from investment

When the formula is used for cost reduction projects the annual incremental income is calculated as follows:

Incremental income = Incremental revenue - Incremental cost including depreciation from investment

Sometime return from investment may be expressed as annual cash flows. We must subtract depreciation when return from investment is expressed as annual cash flows. For example, If an investment costing \$50,000 has a five years life and no salvage value, generated annual cash flows of \$20,000. The average incremental annual income would be:

 Average Annual incremental income = \$20,000 - (\$50,000/5) = \$20,000 - \$10,000 = \$10,000

### Average Investment:

The average investment (denominator in the average rate of return formula) can be either the original cost of the asset or the average investment in the plant asset. The average investment is the midpoint of the depreciable cost of the plant asset. The midpoint is equal to the original cost plus residual value of the asset divided by 2.

## Example of Accounting Rate of Return Method or Average Rate of Return Method:

Management wants to purchase a machine. The machine can replace six workers whose average annual wages and benefits total \$300,000 per year. The cost of machine is \$500,000 and it is estimated that the annual cost to operate the machine will be \$134,000. The expected useful life of the machine is 4 years and expected salvage value is \$60,000.

Should management purchase the machine? Use average rate of return method (accounting rate of return method) to evaluate this investment proposal.

### Solution:

The estimated average annual income is determined as a cost reduction project as follows:

 Total annual labor savings \$300,000 Less: annual operating cost \$134,000 Annual straight-line depreciation (\$440,000/4 years) 110,000 244,000 Average annual incremental income \$56,000 The average investment is \$280,000 [(\$500,000 + \$60,000 residual value) / 2]. Thus, the expected average rate of return on the average investment is 20%, computed as follows: Average rate of return = Estimated average annual incremental income / Average investment = \$56,000 / \$280,000* = 20% * (\$500,000 + \$60,000) / 2 The expected average rate of return is compared with the rate of return set by the management. The machine is desirable if the expected rate of return (20%) exceeds the minimum rate set by the management.

## Comparison of Alternative Proposals:

Management can rank different alternative proposals by their average rates of return. The proposal with the highest average rate of return is considered to be the most desirable. For further clarification consider the following example:

### Example

Management is considering the following alternative capital investment proposals and has the indicated average rates of return:

 Proposal A Proposal B Estimated average annual incremental income \$30,000 \$36,000 Average investment \$120,000 \$180,000 Average rate of return: \$30,000 / \$120,000 25% \$36,000 / \$180,000 20% If only the average rate of return is considered, Proposal A, with an average rate of return of 25%, would be preferred over Proposal B

This method of evaluating capital investment has the following main advantages:

1. It is easy to compute.

2. It includes the amount of income earned over the entire life of the proposal.

3. It emphasizes accounting income, which is commonly used by investors and creditors in evaluating management performance.

The main disadvantage of average rate of return method (accounting rate of return method) is that it does not directly consider the expected cash flows from the proposal and the timing of the cash flows. The cash flows and its timing is very important because cash coming from investment can be reinvested in other income generating activities.

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## More study material from this topic:

 Methods for the evaluation of capital investment analysis Average rate of return or accounting rate of return method Cash payback method Net present value method Internal rate of return method Simple interest Future value of a single sum Future value of an annuity Present value of a single sum Present value of an annuity Qualitative consideration in capital investment analysis Capital investment analysis and unequal proposal lives Capital rationing decision process Difference between simple interest and compound interest Difference between nominal and effective interest rate Future value of \$1 table Present value of \$1 table Present value of ordinary annuity table Future value of ordinary annuity table

A D V E R T I S E M E N T

 Financial Accounting Topics Introduction to Accounting ---------------------------------------------------------------------------- Transactions and Accounting Equation ---------------------------------------------------------------------------- Analysis of Business Transactions ---------------------------------------------------------------------------- Journal, Ledger and Trial Balance ---------------------------------------------------------------------------- Accounting for Bills of Exchange ---------------------------------------------------------------------------- Special Journals ---------------------------------------------------------------------------- Cash Book ---------------------------------------------------------------------------- Bank Reconciliation Statement ---------------------------------------------------------------------------- Final Accounts ---------------------------------------------------------------------------- Work Sheet ---------------------------------------------------------------------------- Capital and Revenue Items ---------------------------------------------------------------------------- Valuation of Inventories ---------------------------------------------------------------------------- Accounts of Non-profit Making Organizations ---------------------------------------------------------------------------- Statement of Cash Flows ---------------------------------------------------------------------------- Accounting Ratios Analysis ---------------------------------------------------------------------------- Depreciation, Provisions and Reserves ---------------------------------------------------------------------------- Accounting Dictionary ---------------------------------------------------------------------------- Financial Calculators

 Managerial Accounting Topics Financial Statements ---------------------------------------------------------------------------- Cost Volume Profit Relationship ---------------------------------------------------------------------------- Variable Costing System ---------------------------------------------------------------------------- Materials and Inventory Cost Control ---------------------------------------------------------------------------- Activity Based Costing System ---------------------------------------------------------------------------- Standard Costing and Variance Analysis ---------------------------------------------------------------------------- Balanced Scorecard ---------------------------------------------------------------------------- Capital Investment Analysis/Capital Budgeting