This exercise illustrates the application of accounting/simple rate of return technique in a cost-cutting project.
Rahat Manufacturing Company uses accounting rate of return (ARR) to analyze investment in plant assets. The company wants to reduce its total annual cost by purchasing a new equipment to be installed in the factory. The relevant information about investment in new equipment is presented to you:
- Amount required to purchase the equipment: $90,000
- Expected annual cost savings: $18,750
- Useful life of the equipment: 16 years
- Straight line depreciation per year: $5,625
- Residual value of the equipment at the end of 16-year period: $0
- Required rate of return: 16%
- Compute accounting rate of return (or simple rate of return) of the equipment.
- Is this investment desirable according to ARR analysis?
(1) Computation of accounting rate of return:
For the purpose of computing equipment’s ARR, we would consider the net annual cost saving as equivalent to incremental revenue. In order to obtain the amount of net annual cost saving, we need to deduct the annual depreciation expense from $18,750 (i.e., the expected cost saving given in the question).
Net annual cost saving = Expected annual cost saving given in the question – Annual depreciation expense
= $18,750 – $5,625
Accounting/simple rate of return = Net cost savings/Initial investment
The accounting rate of return of the equipment is 14.58% which is lower than the minimum desired rate of return of the management. If only accounting rate of return is considered, the investment in this equipment is not acceptable.