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CHAPTER 16

Cost Analysis for Decision Making

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Decision Making
Strategic, Operational, and Financial Planning

Planning and control cycle


Performance analysis: Plans vs. actual results (Controlling)
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Data collection and performance feedback

Executing operational activities (Managing)

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16-3

Relevant Cost Information


A relevant cost is a future cost that differs between alternatives.

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Relevant Cost Information


Will you drive or fly to Colorado for an eight-day spring break ski trip? You have gathered the following information to help you with the decision.  Motel cost is $90 per night.  Meal cost is $25 per day.  Your car insurance is $75 per month.  Kennel cost for your dog is $7 per day.  Round-trip cost of gasoline for your car is $200.  Round-trip airfare and rental car for a week is $700. Driving requires two days, with an overnight stay, cutting your time in Colorado by two days.
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Relevant Cost Information

Colorado Spring Break Drive/Fly Analysis Cost Motel Eating out costs Kennel cost Car insurance Gasoline Airfare/rental car
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Drive $ 720 200 56 75 200 -

Fly $ 720 200 56 75 700

8 days @ $90 8 days @ $25 8 days @ $7

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Relevant Cost Information

Costs do not differ, so they are not relevant to decision. Also, car insurance is not relevant to the decision as it is a past cost.
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Relevant Cost Information

Colorado Spring Break Drive/Fly Analysis Cost Motel Eating out costs Kennel cost Car insurance Gasoline Airfare/rental car
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Drive $ 720 200 56 75 200 -

Fly $ 720 200 56 75 700

Are the two extra days in Colorado worth the $500 extra cost to fly?

Transportation costs differ between the two alternatives, so they are relevant to your decision

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Relevant Cost Information


Relevant
Differential Cost -- will differ according to alternative activities being considered. Opportunity Cost -- income foregone by choosing one alternative over another.

Irrelevant
Allocated Cost -- a common cost that has been arbitrarily assigned to a product or activity. Sunk Cost -- has already been incurred and will not change.

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Opportunity Cost
Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000.

Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.
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The Special Pricing Decision


The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to accept the new business.

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The Special Pricing Decision


MicroTech currently sells 4,400 laptop computers. The company has revenue and expenses as shown below:
Sales Direct materials Direct labor Variable overhead Fixed overhead Total manufacturing cost Sales commission Total expenses Operating income Per Unit $ 2,400 $ 800 450 250 500 $ 2,000 120 $ 2,120 $ 280 $ $ Total 10,560,000 3,520,000 1,980,000 1,100,000 2,500,000 9,100,000 528,000 9,628,000 932,000

$ $ $

Based on capacity of 5,000 units: $2,500,000 5,000 units = $500 per unit.
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The Special Pricing Decision

MicroTech receives an offer to purchase 500 of its laptop computers for $1,800 each. If MicroTech accepts the offer, total fixed overhead will not increase and a selling commission will not be paid on the computers in the special order. Should MicroTech accept the offer?
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The Special Pricing Decision


First lets look at incorrect reasoning that leads to an incorrect decision.

Our manufacturing cost is $2,000 per unit. I cant sell for $1,800 per unit.

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The Special Pricing Decision


This analysis leads to the correct decision.
C B iness Sales ,56 Direct aterials 3,5 Direct lab r ,98 Variable erhead , Fixed erhead ,5 T tal anufacturing costs 9, Sales commission 5 8 Total expenses 9,6 8 perating income 93 S ecial er 9 4 5 5 75 75 5 C bined ,46 3,9 , 5 , 5 ,5 9,85 5 8 ,378 , 8

000s omitted from all numbers.


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The Special Pricing Decision


5 new units ,8 selling price = 9 ,
Combined ,46 3,9 , 5 , 5 ,5 9,85 5 8 ,378 , 8 Current Business Sales ,56 Direct materials 3,5 Direct labor ,98 Variable overhead , Fixed overhead ,5 Total manufacturing costs 9, Sales commission 5 8 Total expenses 9,6 8 perating income 93 Special rder 9 4 5 5 75 75 5

5
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new units 8

= 4

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The Special Pricing Decision


5 new units 45 = 5,
Special rder 9 4 5 5 75 75 5 Combined ,46 3,9 , 5 , 5 ,5 9,85 5 8 ,378 , 8 Current Business Sales ,56 Direct materials 3,5 Direct labor ,98 Variable overhead , Fixed overhead ,5 Total manufacturing costs 9, Sales commission 5 8 Total expenses 9,6 8 perating income 93

5
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new units

5 =

5,
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The Special Pricing Decision


Current Special rder Business Combined Sales ,56 9 ,46 Even though the ,8 selling price is 4 less than the Direct materials 3,5 3,9 normal laborselling price, MicroTech should accept, the Direct ,4 ,98 5 5 offer because net income will increase by 5 , , . 5 Variable overhead , 5 Fixed overhead ,5 ,5 Total manufacturing costs 9, 75 9,85 Sales commission 5 8 5 8 Total expenses 9,6 8 75 ,378 perating income 93 5 , 8

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The Special Pricing Decision


If MicroTech accepts the offer, net income will increase by $150,000.
Increase in revenue (500 $1,800) Increase in variable costs (500 $1,500) Increase in net income $ 900,000 750,000 $ 150,000

We can reach the same results more quickly like this: Special order contribution margin = $1,800 $1,500 = $300 Change in income = $300 500 units = $150,000.
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The Make or Buy Decision


Should I continue to make the part, or should I uy it?

What will I do with my idle facilities if I uy the part?

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16-20

The Make or Buy Decision


The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier. Decision rule: Costs avoided must be greater than outside suppliers price to consider buying the component.

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The Make or Buy Decision


Micro ech currently makes the mother oards used in its laptop computers. Unit cost for manufacturing the mother oards are:
Unit irect Material irect La or aria le erhead i ed erhead otal
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osts

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The Make or Buy Decision


An outside supplier has offered to provide the mother oards at a cost of $300 each plus a $ shipping charge per mother oard. wenty percent of the fi ed overhead will e avoided if the mother oards are purchased. Micro ech has no alternative use for the facilities. Should Micro ech accept the offer?

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The Make or Buy Decision


Differential costs of making (costs avoided if bought from outside supplier):
Unit Cost Direct Material Direct Labor Variable Overhead Fixed Overhead (20% of $100) Total $ 120 80 50 20 270

MicroTech should not pay $305 per unit to an outside supplier to avoid the $270 per unit differential cost of making the part ($35 disadvantage).
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The Make or Buy Decision


If Micro ech uys the mother oards from the outside supplier, the idle facilities could e used to expand production of flat screen monitors that have a contribution margin of $ 0 each. oes this information change Micro echs decision?

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The Make or Buy Decision

anta e of bu in ( ortunit cost of facilities: Monitor contribution ar in A anta e of bu in art isa


The o

ortunit cost of facilities chan es the ecision.

The real question to answer is, What is the best use of MicroTechs facilities?
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Short-Term Allocation of Scarce Resources


Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin.

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Short-Term Allocation of Scarce Resources


Integrated Technologies produces two products and selected data is shown below:
Products 2 1 $ 300 $ 200 150 100 $ 150 $ 100 2 1

Selling price per unit Less: variable expenses per unit Contribution margin per unit Processing time required (hours)

If 120 hours of processing time are available, which product should be produced?
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Short-Term Allocation of Scarce Resources


Lets calculate the contribution margin per hour of processing time.
Products Contribution margin per unit Time required to produce one unit Contribution margin per hour 1 $ 150 2 hours $ 75 2 $ 100 1 hour $ 100

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Short-Term Allocation of Scarce Resources


Lets calculate the contribution margin per hour of processing time.
Products Contribution margin per unit Time required to produce one unit Contribution margin per hour 1 $ 150 2 hours $ 75 2 $ 100 1 hour $ 100

Product 2 should be emphasized. It is the more valuable use of processing time, yielding a contribution margin of $100 per hour as opposed to $75 per hour for Product 1.
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Short-Term Allocation of Scarce Resources


Lets calculate the contribution margin per hour of processing time.
Products Contribution margin per unit Time required to produce one unit Contribution margin per hour 1 $ 150 2 hours $ 75 2 $ 100 1 hour $ 100

If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any time that remains to make Product 1.
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Long-Run Investment Decisions

Lets change topics.

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Capital Budgeting
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

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Capital Budgeting
Outcome is uncertain. Large amounts of money are usually involved.

Capital budgeting: Analyzing alternative long term investments and deciding which assets to acquire or sell. ecision may be difficult or impossible to reverse.
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Investment involves a long term commitment.


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Investment Decision Special Considerations


I will choose the project with the most profitable return on available funds.

Plant Expansion

?
Limited Investment Funds

? ?

New Equipment

Office Renovation
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Investment Decision Special Considerations

Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time.
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Cost of Capital

The firms cost of capital is usually regarded as the most appropriate choice for the discount rate to determine the present value of the investment proposal being analyzed. The cost of capital is the average rate of return the company must pay to its longterm creditors and stockholders for the use of their funds.
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Capital Budgeting Techniques


Methods that use present value analysis: Net present value (NPV). Internal rate of return (IRR).

Methods that do not use present value analysis: Payback. Accounting rate of return.
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Net Present Value (NPV)


A comparison of the present value of cash inflows with the present value of cash outflows

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Net Present Value (NPV)


Chose a discount rate the minimum required rate of return. Calculate the present value of cash inflows. Calculate the present value of cash outflows.

NP =
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Net Present Value (NPV)


General decision rule . . .
If the Net Present Value is . . . Positive . . . Then the Project is . . . Acceptable, since it promises a return greater than the cost of capital. Acceptable, since it promises a return equal to the cost of capital. Not acceptable, since it promises a return less than the cost of capital.
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Zero . . .

Negative . . .

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Net Present Value


BoxMover, Inc. is considering the purchase of a conveyor costing $16,000 with a 7-year useful life and a $5,000 salvage value that promises annual net cash flows as shown in the following table. BoxMovers cost of capital is 12 percent. Ignoring taxes, compute the NPV for this investment.

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Net Present Value


Present Present Annual Net Value of $1 Value of Cash Flows Year Factor Cash Flows 1 $ 4,000 0.89286 $ 3,571 2 4,200 0.79719 3,348 3 4,200 0.71178 2,989 4 4,400 0.63552 2,796 5 4,800 0.56743 2,724 6 4,000 0.50663 2,027 7 3,800 0.45235 1,719 salvage 5,000 0.45235 2,262 Total $ 34,400 $ 21,436 Amount to be invested (16,000) Net present value of investment $ 5,436
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Net Present Value


Present value factors Present Annual Net Value of $1 for 12 percent
Cash Flows Year Factor 1 $ 4,000 0.89286 2 4,200 0.79719 3 4,200 0.71178 4 4,400 0.63552 5 4,800 0.56743 6 4,000 0.50663 7 3,800 0.45235 salvage 5,000 0.45235 Total $ 34,400 Amount to be invested Net present value of investment
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Present Value of Cash Flows $ 3,571 3,348 2,989 2,796 2,724 2,027 1,719 2,262 $ 21,436 (16,000) $ 5,436

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16-44

Net Present Value


Present Present Annual Net Value of $1 Value of Cash Flows Year Factor Cash Flows 1 $ 4,000 0.89286 $ 3,571 2 4,200 0.79719 3,348 3 4,200 0.71178 2,989 4 4,400 0.63552 2,796 5 4,800 0.56743 2,724 6 4,000 0.50663 2,027 A positive net present value indicates that this 7 3,800 1,719 project earns more than 0.45235 12 percent, so the salvage 5,000 0.45235 2,262 investment should be made. Total $ 34,400 $ 21,436 Amount to be invested (16,000) Net present value of investment $ 5,436
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Net Present Value (NPV)


Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Browns cost of capital return is 12 percent, what is the NPV? Ignore taxes. a. b. c. d. $ 4,300 $12,700 $11,000 $17,000
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16-46

Net Present Value (NPV)


Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Browns cost of capital return is 12 percent, what is the NPV? Ignore taxes. a. b. c. d. $ 4,300 P of inflows = $20,000 . 0 = $113,000 $12,700 NP = $113,000 $9 ,000 = $1 ,000 $11,000 $17,000
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Using the present value of an annuity

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16-47

Net Present Value (NPV)


Calculate the NP if rown Companys cost of capital is 1 percent instead of 12 percent.
Using the present value of an annuity P of inflows = $20,000 .019 = $100,380 NP = $100,380 $9 ,000 = $ ,380

Note that the NP is smaller using the larger interest rate.


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Ranking Investment Projects


Profitability = index Present value of cash inflows Investment required
Investment Present value of cash inflows Investment required Profitability index , , . , , .

The higher the profitability index, the more desirable the project.

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Internal Rate of Return (IRR)


The actual rate of return that will be earned by a proposed investment. The interest rate that equates the present value of inflows and outflows from an investment project the discount rate at which NPV = 0.

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Internal Rate of Return (IRR)


Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.

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Internal Rate of Return (IRR)


Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
P factor for the = internal rate of return $10 , 320 $20,000 Investment required Net annual cash flows = .21

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Internal Rate of Return (IRR)


Using the present value of an annuity of $1 table . . . Find the 10 period row, move across until you find the factor .21 . Look at the top of the column %. and you find a rate of 1 %
e r io d s 1 2 . . . 10 10% 0. 0 1. . . . . .1 12% 0. 1. 0 . . . . 2 . 0 1 % 0. 1. . . . . .2 1

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16-53

Internal Rate of Return (IRR)


Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. The internal rate of return on this project is 1 %. If the internal rate of return is equal to or greater than the companys required rate of return, the project is acceptable.
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Internal Rate of Return (IRR)


If cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.

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Some Analytical Considerations


Sensitivity analysis and post audits are helpful in dealing with estimates. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows are assumed to occur at the end of the year. Some projects will require additional investments over time.

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Some Analytical Considerations


Often, after-tax cash flow can be estimated by adding depreciation to income. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the projects life. Least cost projects, often required by law, will have negative NPVs.

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Some Analytical Considerations


Jones company is considering purchasing a machine with a year life and $ ,000 salvage value.
ost a nd re ve nue inform a tion $ ,000 ost of m a chine e ve nue $ ,000 ost of goods sold 0,000 Gross profit $ ,000 a sh ope ra ting costs $ ,000 e pre cia tion 0,000 ,000 re ta incom e $ ,000 ncom e ta , 00 fte r ta incom e $ , 00

($55,000 - $5,000) 5 years


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Some Analytical Considerations


Most capital budgeting techniques use annual net cash flow. epreciation is not a cash outflow.

nnual net inco e dd annual depreciation nnual net cash flow


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Payback Period
The payback period of an investment is the number of years it will take to recover the amount of the investment.
Managers prefer investing in projects with shorter payback periods.

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Payback Period
Cumulative et Cash lows $ 1 ,000 1 ,000 , 00 ,000 , 00 1,000 , 00 , 00 10, 00

TexCo wants to install a machine that costs $1 ,000 and has an 8 year useful life with $1,000 salvage value. Annual net cash flows are:

Year 0 1

8
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Annual et Cash lows $ 1 ,000 ,000 , 00 , 00 , 00 , 00 , 00 ,000 3,000

Includes salvage

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Payback Period
T x c h 1 , p ch p ic b w y 4 d , b 4. y f h p yb ck p i d.
4.

A Y

N hF w 4 3, 3, 3, 3, 3, 3, 3,

N F w 3, ( , ( , ( , 1, 4, , 1 ,

3 4

) ) ) )

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16-62

Payback Period

Ignores the time value of money.

Ignores cash flows after the payback period.


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Payback Period
Consider two projects, each with a five-year life and each costing $6,000.
Proj t Net I flow , , , , , Proj t wo Net I flow , , , , , ,

Year

Would you i vest i Project e just because it as a shorter payback period?


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16-64

Accounting Rate of Return


The accounting rate of return focuses on accounting income instead of cash flows.

Accounting rate of return

Operating income Average investment

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16-65

Accounting Rate of Return


Reconsider the $17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return.
Accounting rate of return = Operating income Average investment

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Accounting Rate of Return


Depreciation ($17,000 - 1,000) 8 years Reconsider the=$17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return.

Cash flow Depreciation Operating income

$ 4,000 2,000 $ 2,000

Accounting rate of return

O perating incom e Average investm ent

Beg in n in g bo o k value + En din g bo o k value 2


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Accounting Rate of Return


Reconsider the $17,000 investment being considered by TexCo. The annual operating income is $2,000. Compute the accounting rate of return.
Accounting rate of return = $2,000 $9,000 = 22.2%

$1 ,000 + $1,000 2
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Accounting Rate of Return


Depreciation may be calculated several ways. Income may vary from year to year. Time value of money is ignored.
So why would I ever want to use this method anyway?

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End of Chapter 16

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