16-1

CHAPTER 16

Cost Analysis for Decision Making

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc., All Rights

16-2

Decision Making

Revisit Plans

LO1

Performance
analysis:
Plans vs.
actual results
(Controlling)

Strategic,
Operational, Implement Plans
and Financial
(Planning)

Planning and Control Cycle

Executing
operational
Data collection and Performance Feedback
activities
(Managing)

16-3

LO1

Relevant Cost Information

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

16-4

LO1

Relevant Cost Information

16-5

LO1

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.

16-6

LO2

Relevant Cost Information

Will
Willyou
youdrive
driveor
orfly
flyto
toColorado
Coloradofor
foraaspring
springbreak
breakski
skitrip?
trip?

You
Youhave
havegathered
gatheredthe
thefollowing
followinginformation
informationto
tohelp
helpyou
youwith
with
the
thedecision.
decision.

Motel
Motelcost
costisis$90
$90per
pernight.
night.

Meal
Mealcost
costisis$25
$25per
perday.
day.

Your
Yourcar
carinsurance
insuranceisis$75
$75per
permonth.
month.

Kennel
Kennelcost
costfor
foryour
yourdog
dogisis$7
$7per
perday.
day.

Round-trip
Round-tripcost
costof
ofgasoline
gasolinefor
foryour
yourcar
carisis$200.
$200.

Round-trip
Round-tripairfare
airfareand
andrental
rentalcar
carfor
foraaweek
weekisis$700.
$700.

Driving
Drivingrequires
requirestwo
twodays,
days,with
withan
anovernight
overnightstay,
stay,cutting
cuttingyour
your
time
timein
inColorado
Coloradoby
bytwo
twodays.
days.

16-7

LO2

Relevant Cost Information

Colorado Spring Break
Drive/Fly Analysis

Cost
Motel
Meals
Kennel cost
Car insurance
Gasoline
Airfare/rental car

Drive
$ 720
200
56
75
200
-

Fly
$ 720
200
56
75
700

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

16-8

LO2

Relevant Cost Information

Colorado Spring Break

Drive/Fly Analysis
Cost
Motel
Meals
Kennel cost
Car insurance
Gasoline
Airfare/rental car

Drive
$ 720
200
56
75
200
-

Fly
$ 720
200
56
75
700

Costs do not differ,

so they are not
relevant to decision.
Also, car insurance
is not relevant to
the decision as it
is a sunk cost.

16-9

LO2

Relevant Cost Information

Colorado Spring Break

Drive/Fly Analysis
Cost
Motel
Meals
Kennel cost
Car insurance
Gasoline
Airfare/rental car

Drive
$ 720
200
56
75
200
-

Fly
$ 720
200
56
75
700

Are
Arethe
thetwo
twoextra
extra
days
days in
inColorado
Colorado
worth
worththe
the$500
$500
extra
extracost
cost to
tofly?
fly?
Transportation
costs differ between
the two alternatives,
so they are relevant
to your decision.

16-10

LO3

The Special Pricing Decision

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

16-11

LO3

The Special Pricing Decision

MicroTech currently sells 4,400 laptop
computers. The company has revenue
and expenses as shown below:

Based on capacity of 5,000 units:

$2,500,000 5,000 units = $500 per unit.

16-12

LO3

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?

16-13

LO3

The Special Pricing Decision

First
First lets
letslook
lookat
at incorrect
incorrect reasoning
reasoning
that
that leads
leadsto
toan
an incorrect
incorrect decision.
decision.
Our manufacturing cost
is $2,000 per unit. I
cant sell for $1,800
per unit.

16-14

LO3

The Special Pricing Decision

This analysis leads to the correct decision.

000s omitted from all numbers.

16-15

LO3

The Special Pricing Decision

500 new units $1,800 selling price = $900,000

500 new units $800 = $400,000

16-16

LO3

The Special Pricing Decision

500 new units $450 = $225,000

Current
Current
Business
Business
Sales
$$ 10,560
Sales
10,560
Direct
$$ 3,520
Direct materials
materials
3,520
Direct
1,980
Direct labor
labor
1,980
Variable
1,100
Variable overhead
overhead
1,100
Fixed
2,500
Fixed overhead
overhead
2,500
Total
Total manufacturing
manufacturing costs
costs $$ 9,100
9,100
Sales
528
Salescommission
commission
528
Total
$$ 9,628
Total expenses
expenses
9,628
Operating
$$
932
Operating income
income
932

Special
Special
Order
Order
$$ 900
900
$$ 400
400
225
225
125
125
00
$$ 750
750
00
$$ 750
750
$$ 150
150

500 new units $250 = $125,000

Combined
Combined
$$ 11,460
11,460
$$ 3,920
3,920
2,205
2,205
1,225
1,225
2,500
2,500
$$ 9,850
9,850
528
528
$$ 10,378
10,378
$$ 1,082
1,082

16-17

LO3

The Special Pricing Decision

Current

Special

CurrentpriceSpecial
Even though the $1,800 selling
is less than the
Business
Order
Combined
Business
Order
Combined
normal $2,400 selling price, MicroTech should accept
the
Sales
$
10,560
$
900
$
11,460
Sales
$ 10,560
$
900
$ 11,460
offer because net income
will increase
by $150,000.
Direct
Direct materials
materials
Direct
Direct labor
labor
Variable
Variable overhead
overhead
Fixed
Fixed overhead
overhead
Total
Total manufacturing
manufacturing costs
costs
Sales
Salescommission
commission
Total
Total expenses
expenses
Operating
Operating income
income

$$ 3,520
3,520
1,980
1,980
1,100
1,100
2,500
2,500
$$ 9,100
9,100
528
528
$$ 9,628
9,628
$$
932
932

$$

$$
$$
$$

400
400
225
225
125
125
00
750
750
00
750
750
150
150

$$

$$
$$
$$

3,920
3,920
2,205
2,205
1,225
1,225
2,500
2,500
9,850
9,850
528
528
10,378
10,378
1,082
1,082

16-18

LO3

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 operating 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.

16-19

LO3

The Make or Buy Decision

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

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

16-20

The Make or Buy Decision

LO3

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.

16-21

LO3

The Make or Buy Decision

MicroTech
MicroTech currently
currently makes
makes the
the motherboards
motherboards
used
used in
in its
its laptop
laptop computers.
computers. Unit
Unit costs
costs for
for
manufacturing
manufacturing the
the motherboards
motherboards are:
are:
Unit Costs
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Total

120
80
50
100
350

16-22

LO3

The Make or Buy Decision

An outside supplier has offered to provide the
motherboards at a cost of $300 each plus a $5
shipping charge per motherboard. Twenty percent
of the fixed overhead will be avoided if the
motherboards are purchased. MicroTech has no
alternative use for the facilities.
Should MicroTech accept the offer?

16-23

LO3

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).

16-24

LO3

The Make or Buy Decision

If MicroTech buys the motherboards from
the outside supplier, the idle facilities
could be used to expand production of
flat screen monitors that have a
contribution margin of $50 each.
Does this information change MicroTechs
decision?

16-25

LO3

The Make or Buy Decision

Disadvantage of buying ( $305 - $270 )

Opportunity cost of facilities:
Monitor contribution margin
Advantage of buying part

$ 35
50
$ 15

The opportunity cost of facilities changes the decision.

The
The real
real question
question to
to answer
answer is:
is:
What
What is
is the
the best
best use
use of
of MicroTechs
MicroTechs facilities?
facilities?

16-26

LO3

Continue or Discontinue a Segment

CRUISERS, INC.
Segmented Income Statement
For the Year Ended December 31st

Sales
Variable expenses
Contribution Margin
Fixed expenses
Operating income

Total
Company
$ 2,240,000
960,000
1,280,000
1,128,000
$ 152,000

Repair
Sailboat Motorboat
Parts
Division
Division
Division
$ 1,280,000 $ 640,000 $ 320,000
512,000
288,000
160,000
768,000
352,000
160,000
656,000
288,000
184,000
$ 112,000 $ 64,000 $ (24,000)

Discontinue the
Repair Parts
Division and
increase
operating income
by $24,000

16-27

LO3

Continue or Discontinue a Segment

Analysis of Fixed Expenses

Repair
Total
Sailboat Motorboat
Parts
Company
Division
Division
Division
Direct fixed Expenses $ 680,000 $ 400,000 $ 160,000 $ 120,000
Common fixed expenses
allocated in proportion
to sales
448,000
256,000
128,000
64,000
Total fixed expenses $ 1,128,000 $ 656,000 $ 288,000 $ 184,000

What about
fixed
expenses?

16-28

LO3

Continue or Discontinue a Segment

We must eliminate more in fixed expenses than the
amount of contribution margin we are losing.

Closing the Repair Parts Division will eliminate:

Sales
Variable Expenses
Contribution Margin

$320,000
160,000
160,000

Relevant Cost Analysis

of Discontinuing the Repair Parts Division
Decrease in Contribution Margin
Direct fixed expenses (Repair Parts Division)
Net decrease in contribution margin

(160,000)
120,000
(40,000)

16-29

LO3

Continue or Discontinue a Segment

Sales
Variable expenses
Contribution Margin
Fixed expenses
Operating income

Total
Company
$ 2,240,000
960,000
1,280,000
1,128,000
$
152,000

Sailboat
Division
$ 1,280,000
512,000
768,000
656,000
$ 112,000

Motorboat
Division
$ 640,000
288,000
352,000
288,000
$ 64,000

Operating Income with Repair Parts Division

Operating Income without Repair Parts Division
Decrease in Operating Income

Repair
Parts
Division
$ 320,000
160,000
160,000
184,000
$ (24,000)

$152, 000
(112,000)
$ 40,000

Operating Income
Decreases by
$40,000 if we
discontinue the
Repair Parts
Division.

16-30

LO3

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.

16-31

LO3

Short-Term Allocation
of Scarce Resources
Integrated Technologies produces two products
and selected data are shown below:
Products

Selling price per unit

Less: variable expenses per unit
Contribution margin per unit

1
$ 300
150
$ 150

2
$ 200
100
$ 100

Processing time required (hours)

If 120 hours of processing time are available,

which product should be produced?

16-32

LO3

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

16-33

LO3

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.

16-34

LO3

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 enough products to meet current demand
for Product 2 and then use of any remaining time to
make Product 1.

16-35

LO4

Long-Run Investment Decisions

Lets
change
topics.

16-36

LO4

Capital Budgeting
Managers must plan significant outlays for
projects that have long-term implications
such as the purchase of new equipment
and introduction of new products.

16-37

LO4

Capital Budgeting
Outcome
is uncertain.

Large amounts of
money are usually
involved.

Capital budgeting:
Analyzing alternative longterm investments and deciding
which assets to acquire or sell.

Decision may be
difficult or impossible
to reverse.

Investment involves a
long-term commitment.

16-38

LO4

Investment Decision Special

Considerations
I will choose the
project with the most
profitable return on
available funds.
Limited
Investment
Funds

?
?
?

Plant
Expansion
New
Equipment
Office
Renovation

16-39

Investment Decision Special

Considerations

LO5

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.

16-40

LO6

Cost of Capital

The firms cost of capital is usually

regarded as the most appropriate
choice for the discount rate used to
calculate 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 long-term creditors and
stockholders for the use of their
funds.

16-41

LO6

Capital Budgeting Techniques

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

Methods
Methods that
that do
do not
not use
use present
present value
value analysis:
analysis:
Payback.
Payback.
Accounting
Accounting rate
rate of
of return.
return.

16-42

LO7

Net Present Value (NPV)

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

16-43

LO7

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.

NPV =

16-44

LO7

Net Present Value (NPV)

General decision rule . . .
If the Net Present
Value is . . .

Then the Project is . . .

Positive . . .

Acceptable, since it promises a

return greater than the cost of
capital.

Zero . . .

Acceptable, since it promises a

return equal to the cost of
capital.

Negative . . .

Not acceptable, since it

promises a return less than the
cost of capital.

16-45

LO7

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.
Annual net cash flows are shown in the
following table. BoxMovers cost of capital
is 12 percent. Ignoring taxes, compute the
NPV for this investment.

16-46

LO7

Net Present Value

16-47

LO7

Net Present Value

Present value factors

for 12 percent

16-48

LO7

Net Present Value

A positive net present value indicates that this

project earns more than 12 percent, so the
investment should be made.

16-49

Net Present Value (NPV)

LO7

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

$$ 4,300
4,300
$12,700
$12,700
$11,000
$11,000
$17,004
$17,004

16-50

Net Present Value (NPV)

LO7

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

Using the present value of an annuity

$$ 4,300
4,300
PV of inflows = $20,000 5.6502 = $113,004
$12,700
$12,700
NPV = $113,004 - $96,000 = $17,004
$11,000
$11,000
$17,004
$17,004

16-51

LO7

Net Present Value (NPV)

Calculate
Calculate the
the NPV
NPV ifif Brown
Brown Companys
Companys cost
cost of
of
capital
capital is
is 14
14 percent
percent instead
instead of
of 12
12 percent.
percent.
Using the present value of an annuity
PV of inflows = $20,000 5.2161 = $104,322
NPV = $104,322 - $96,000 = $8,322

Note that the NPV is smaller

using the larger interest rate.

16-52

LO7

Ranking Investment Projects

Profitability
=
index

Present value of cash inflows

Investment required
Investment

A
Present value of cash inflows $81,000
Investment required
80,000
Profitability index
1.01

B
$6,000
5,000
1.20

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

16-53

Internal Rate of Return (IRR)

LO7

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.

16-54

Internal Rate of Return (IRR)

LO7

Decker Company can purchase a new

machine at a cost of $104,322 that will save
$20,000 per year in cash operating costs.

The machine has a 10-year life.

16-55

LO7

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:
PV factor for the
=
internal rate of return
$104, 322
$20,000

Investment required
Net annual cash flows
= 5.2161

16-56

LO7

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 5.2161. Look at the top
of the column and you find a rate of 14%.
14%

16-57

Internal Rate of Return (IRR)

LO7

Decker Company can purchase a new

machine at a cost of $104,322 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 14%.
If the internal rate of return is equal to
or greater than the companys required
rate of return, the project is acceptable.

16-58

LO7

Internal Rate of Return (IRR)

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

16-59

Some Analytical Considerations

LO8

Sensitivity
Sensitivity analysis
analysis and
and post
post audits
audits are
are
helpful
helpful in
in dealing
dealing with
with estimates.
estimates.

Cash
Cash flows
flows far
far into
into the
the future
future are
are often
often not
not
considered
considered because
because of
of uncertainty
uncertainty and
and aa
small
small impact
impact on
on present
present values.
values.

Cash
Cash flows
flows are
are assumed
assumed to
to occur
occur
at
at the
the end
end of
of the
the year.
year.

Some
Some projects
projects will
will require
require
additional
additional investments
investments over
over time.
time.

16-60

LO8

Some Analytical Considerations

Often,
Often, after-tax
after-tax cash
cash flow
flow can
can be
be estimated
estimated by
by
adding
adding back
back depreciation
depreciation expense
expense (a
(a noncash
noncash
item)
item) to
to net
net income.
income.

Increased
Increased working
working capital
capital is
is initially
initially treated
treated as
as an
an
additional
additional investment
investment (cash
(cash outflow)
outflow)
and
and as
as aa cash
cash inflow
inflow ifif recovered
recovered at
at
the
the end
end of
of the
the projects
projects life.
life.

Least
Least cost
cost projects,
projects, often
often required
required
by
by law,
law, will
will have
have negative
negative NPVs.
NPVs.

16-61

LO8

Some Analytical Considerations

Jones Company is considering purchasing a machine that costs

$55,000 with a 5-year life and $5,000 salvage value.

Cost and revenue information

$ 55,000
Cost of machine
Revenue
$ 76,000
Cost of goods sold
50,000
Gross profit
$ 26,000
Cash operating costs
$ 5,000
Depreciation
10,000
15,000
Pretax income
$ 11,000
Income tax
4,400
After-tax income
$ 6,600

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

16-62

LO8

Some Analytical Considerations

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

Annual net income

$ 6,600
Add back annual depreciation
10,000
Annual net cash flow
$ 16,600

16-63

LO9

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

16-64

LO9

Payback Period

TexCo wants to
install a machine
that costs $17,000
and has an 8-year
useful life with
$1,000 salvage
value. Annual net
cash flows are:

Year
0
1
2
3
4
5
6
7
Includes salvage 8

Annual Net
Cash Flows
$ (17,000)
4,000
3,500
3,500
3,500
3,500
3,500
3,000
3,000

Cumulative
Net Cash
Flows
$ (17,000)
(13,000)
(9,500)
(6,000)
(2,500)
1,000
4,500
7,500
10,500

16-65

LO9

Payback Period

TexCo recovers the

$17,000 purchase price
between years 4
and 5, about 4.7
years for the
payback period.
2,500/3,500 = .7 years + 4 years

Year
0
1
2
3
4
4.7
5
6
7
8

Annual Net
Cash Flows
$ (17,000)
4,000
3,500
3,500
3,500
3,500
3,500
3,000
3,000

Cumulative
Net Cash
Flows
$ (17,000)
(13,000)
(9,500)
(6,000)
(2,500)
1,000
4,500
7,500
10,500

16-66

LO9

Payback Period

Ignores the
time value
of money.

Ignores cash
flows after
the payback
period.

16-67

LO9

Payback Period
Consider two projects, each with a five-year
life and each costing $6,000.
Yes...
Payback
Period
ignores all
future cash
flows after
the
payback
period
Would you invest in Project One just because
it has a shorter payback period?

16-68

L O 10

Accounting Rate of Return

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

Accounting
Accounting =
rate
rateof
ofreturn
return

Operating
Operating income
income
Average
Averageinvestment
investment

16-69

L O 10

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
Accounting
rate
rateof
ofreturn
return

Operating
Operatingincome
income
Average
Averageinvestment
investment

16-70

L O 10

Cash flow
Depreciation
Operating income

$ 4,000
2,000
$ 2,000

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.

Accounting
Accounting
rate
rateof
ofreturn
return

Operating
Operatingincome
income
Average
Averageinvestment
investment

Beginning book value + Ending book value

2

16-71

L O 10

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
Accounting
rate
rateof
ofreturn
return

$$2,000
2,000
$16,000
$16,000

$17,000 + $15,000
2

12.5%

16-72

Accounting Rate of Return

L O 10

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?

16-73

L O 11

Investment Decisions
In addition to the consequences of various quantitative
models, managements investment decisions are
influenced by such qualitative factors as:
1.
A business segment requiring special consideration;
2.
Mandatory regulations and goals;
3.
Technological developments within the industry; and
4.
Limited resources and capital rationing.

1
4

16-74

End of Chapter 16