Simple Rate of Return

Learning Outcomes

  • Describe the simple rate of return method

The simple rate of return is calculated by taking the annual incremental net operating income and dividing by the initial investment. When calculating the annual incremental net operating income, we need to remember to reduce by the depreciation expense incurred by the investment.

Watch IT

Let’s take a look at an example.

Hupana Running Company is looking at adding a stitcher that will add $40,000 to the revenues of the company per year. The incremental (additional) cash operating expenses of this piece of equipment would be $5,000 per year, and the equipment has a cost of $100,000 with a 5 year life and no salvage value. So let’s pop these numbers into the formula:

Hupana Running Company—Stitcher Purchase
Annual incremental revenue $40,000
Annual incremental operating expense $5,000
Annual depreciation ($100,000/5 years) $20,000
Annual incremental expenses $25,000
Annual incremental net operating income/(loss) $15,000

So the simple rate of return would be: annual incremental net operating income/ initial investment cost

$15,000/$100,000= 15% simple rate of return

So it looks like the stitcher would be a good investment!  What if we change up the numbers a bit. The stitcher will still add the $40,000 to revenues, but will add $10,000 to annual operating costs and only have a useful life of three years.

Hupana Running Company—Stitcher Purchase
Annual incremental revenue $40,000
Annual incremental operating expense $10,000
Annual depreciation ($100,000/ years) $33,333
Annual incremental expenses $43,333
Annual incremental net operating income/(loss) −$3,333

We now have a negative rate of return, so would probably pass on making this purchase. This brings home the point of how important it can be to know your numbers and do your research! Also noting, a small difference, can make a huge difference in the decision to make a capital budgeting decision, so as a manager, be clear on your information and perhaps use several of the available methods before making a final decision or before taking your analysis to your supervisor!

Practice Questions

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For additional practice look at this exercise on the simple rate of return method.