Calculate Average Accounting Return

A toilet manufacturer is considering building a new production plant in a new town. It will require an initial capital investment of $12 million and the plant will be depreciated on a straight-line basis over the next four years of its use. The new project will generate incremental net income of $900,000, $1,350,000, $1,200,000 and $1,950,000 over each of the next four years for the company. What is the average accounting return (AAR) for this project?


How to solve for Average Accounting Rate of Return?

The AAR (Average Accounting Rate of Return) measures the average accounting profit earned on the average amount of capital invested over a project's life span for a company. Assets are normally depreciated on a straight-line basis with the method. Therefore the average book value formula is solved by dividing the initial investment by the length of the project's expected life:

Average book value of assets: $12,000,000/2 = $6,000,000

This assumes a beginning value of $12,000,000 and an ending value of $0. Hence, they have an average value of $6,000,000.

Next you must calculate average net income over the period:

($900,000+$1,350,000+$1,200,000+$1,950,000)/4 = $1,350,000

The Average Accounting Return (AAR) Equation is:

AAR= Average Net Income/Average Book Value

= $1,350,000/$6,000,000
= .225 or 22.5%

Using the Average Accounting Rate of Return (AAR) formula and equation is good capital budgeting tool because managers can compare it to objective benchmarks and past perfomance.

External Links:
Evaluating Business Investments
What is Residual Income?
What is Working Capital Management?

How to Calculate Operating Income in a Merchandising Operation

Operating income in a merchandising company is the difference between gross margin and selling and administrative expenses.

Total Sales
- Cost of Good Sold (COGS)
=Gross Margin
- Selling and Administrative Expenses
= Operating Income

Financial Statements

What is Contribution Margin

Contribution Margin

Understanding Contribution Margin (CM) is an essential part of variable costing and managerial accounting.

CM = Selling Price - Variable Costs

It is calculated as either CM per unit or total CM.

CM is the profit available to cover fixed costs during the manufacturing process and provide net income to shareholders

Additional Examples:
Finding Contribution Margin (CM)

Difference Fixed Cost Variable Cost

Variable Cost Ratio Example

Calculate Total Overhead Budget

Using the Accounting Equation and Example problems

The assets of a particular business belong to resource providers who have claims on these assets. In other terms, every asset has its own source provided by either an owner or a creditor. Therefore, there may not be any claim without an appropriate asset or vice versa. The accounting equation is:

Assets = Claims

Claims are divided into two categories: owners' claims (equity) and creditors' claims (liabilities):

	_ Claims
Assets =	Liabilities + Equity

Accounting Equation Formula:

				Equity
Assets	=	Liabilities	+	Contributed Capital	+	Retained Earnings

	Claims
Assets =	Liabilities + Equity
$700 =	$300 + $400

1. Fun Company purchases a machine for $18,000 on credit, and a month later makes a partial payment of $10,000 for the machine. The overall result of the 2 transactions combined will cause:

A. Total Equity to decrease by $8,000
B. Total Liabilities to increase by $8,000
C. Total Assets to decrease by $8,000
D. Total Assets to remain unchanged
E. Total Assets to decrease by $10,000


2. If the liabilities of a business increased $92,000 during a period and the assets in the business increased $30,000 during the same period, the equities of the business must have:

A. Decreased $62,000
B. Decreased $122,000
C. Increased $122,000
D. Decreased $92,000
E. Increased $62,000






Answers to Problems:

1.B
2.A

Additional Links to Accounting Problems and Examples:

Accumulated Depreciation Balance Sheet

Common Size Balance Sheet
How to Calculate Net Income
Accounting Financial Statements
Credit Sales and Purchases Accounting Problems

Accounting Bank Reconciliation

External Links:

Accounting Equation
Using Debits and Credits

Accounting Equation Worksheet

What is Indirect Labor?

Indirect Labor describes employees in a manufacturing company who are not directly involved with the production of goods. Therefore, they are not considered direct labor.

Janitorial Staff, Mechanics, and loading dock workers are all examples of indirect labor under management accounting. Even if they handle products produced by a manufacturer, their wages are not to be calculated into product costs.

Percent of Accounts Receivable Method for Estimating Bad Debts Expense

Calculating the Percent of Accounts Receivable Method for Estimating Bad Debts Expense

Calculate the estimate of the Allowance for Doubtful Accounts.

Year-end Accounts Receivable × Bad Debt %

Bad Debts Expense is computed as:

Estimated Adjusted Balance in Allowance for Doubtful Accounts
-Unadjusted Year-End Balance in Allowance for Doubtful Accounts
=Estimated Bad Debts Expense


Accounts Receivable - January 1, 2005 $130,000

Credit sales during 2005 $720,000

Collections from credit customers during 2005 $690,000

Customer accounts considered uncollectible during 2005 $5,000

Allowance for Doubtful Accounts on January 1, 2005 $4,900


If a small business estimates 7.5% of its accounts receivables to be uncollectible, what amount should be recorded as bad debt expense on December 31, 2005 with a journal entry to the accounting records?




$11,725

Percent of Sales Method for Estimating Bad Debts Expense

Percent of Sales Method to Calculate Debt Expense


Bad debts expense is calculated as a straight percentage of the current years credit sales. The percentage is based on prior years experience, modified for changes in current year. Any existing balance in the Allowance for Doubtful Accounts is NOT considered in calculating Bad Debts Expense.

To record bad debt expense use the following equation:

Current Period Sales X Bad Debt %

= Estimated Bad Debts Expense





An Internet Service Provider estimates its bad debts expense to be 2 percent of credit sales. Their credit sales for 2006 were $1,000,000. During the year 2006, the Internet Service Provider wrote off $18,000 of uncollectible accounts.

Their Allowance for Doubtful Accounts had a $15,000 balance on January 1, 2006. On its December 31, 2006 balance sheet, what amount should the ISP enter as a journal entry for Allowance for Doubtful Accounts?





Answer: $17,000

Additional Links to Accounting Tutorials:

Direct Write Off Method for Bad Debt

What is Bad Debt?

Calculate Total Overhead Budget

In a computer manufacturing firm, a flexible budget for 20,000 hours showed variable manufacturing overhead of $4 per hour and fixed manufacturing overhead of $2.50 per hour. Assume 10,000 hours is within the relevant range, calculate total overhead budget for 10,000 hours.

VC = $4 x 10,000 = $40,000

FC = $2.50 x 20,000 = $50,000

Total costs = $90,000

External Links:
Manufacturing Overhead Tutorial

Calculate Direct Material (DM) Purchase Budget

Absorption Costing and CVP Analysis

Absorption costing will not support CVP analysis because it treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to units of production.


Treating fixed manufacturing overhead as a variable cost can:

1. Lead to faulty pricing decisions
2. Create wrong drop/add decisions
3. Produce positive net operating income while the number of units sold is less than the breakeven point.

More information on CVP Analysis

Manufacturing Overhead Variable Cost

CVP Relationships Income Statement

Assumptions of CVP Analysis

What is Sunk Cost Definition?

It is a sunk cost that has been incurred by a company and cannot be reversed. It should be ignored in capital budgeting decisions. Another name for sunk cost is "stranded cost." An example of a sunk cost could be research that is never ended up being used. It could be marketing oppurunities never taken advantage of.

Expanded ROI Formula

ROI = income ÷ invested capital

Expanded Return on Investment (ROI) Formula

ROI = income ÷ invested capital
ROI = (income ÷ sales) x (sales ÷ invested capital)
ROI = sales margin x investment turnover ratio

Amount of profit earned on every dollar invested.


Underlying reasons of Return on Investment (ROI) Equation

Profitability of Sales ---------- Profit/Sales Margin
Efficiency of Sales Generation --- Capital/Investment Turnover Ratio


Additional Accounting Examples and Explanations:

Calculate Invested Capital
Ratio Analysis and Financial Control

Calculate Gross Margin Financial Ratio

Expanded ROA Equation

Calculate Fixed Ass Turnover Ratio