Accounting Rate of Return (ARR) Method of Capital Budgeting

Accounting Rate of Return (ARR) Method

Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out.

The Accounting Rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.

Accounting Rate of Return (ARR) = Average income / Average investment

There are two variants of the accounting rate of return; Original Investment Method, and Average Investment Method.

1. Original Investment Method. Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average annual profits and original investment established. We can express the ARR in the following way.

Accounting Rate of Return (ARR) = Average annual profits over the life of the project / Original Investment

2. Average Investment Method: Under average investment method, average annual earnings are divided by the average amount of investment. Average investment is calculated, by dividing the original investment by two or by a figure representing the mid-point between the original outlay and the salvage of the investment. Generally accounting rate of return method is represented by the average investment method.

Rate of Return. Rate of Return, as the term is used in our foregoing discussion, may be calculated by taking (a) income before taxes and depreciation, (b) income before tax and after depreciation.… Read the rest

Payback Period Method of Capital Budgeting

Payback Period Method

The Payback period method of capital budgeting is popularly known as pay-off, pay out or replacement period methods also. It is the most popular and widely recognized traditional method of evaluating capital projects.

Payback period method represents the number of years required to recover the original cash outlay invested in a project. It is based on the principle that every capital expenditure pays itself back over a number of years. It attempts to measure the period of time, it takes for the original cost of a project to be recovered from the additional earnings of the project. It means where the total earnings (or net cash inflow) from investment equals the total outlay, that period is the pay-back period. The standard recoupment period is fixed the management taking into account number of considerations. In making a comparison between two or more projects, the project having the lesser number of pay-back years within the standard recoupment limit will be accepted. Suppose, if an investment earns Rs. 5000 cash proceeds in each of the first two years of its use, the payback period will be two years.

For this purpose, net cash inflow shall be calculated first in the following manner:-

Cash inflow from sales revenue                                   ……………………………………
Less operating expenses including depreciation       ……………………………………

Net income (before tax)                                               ……………………………………

Less-Income tax                                                           …………………………………….


Net income (after tax)                                                 ……………………………………..

Add depreciation                                                          ……………………………………..


Net cash inflows                                                           ……………………………………..


Note: As because depreciation does not affect the cash inflow, it shall not be taken into consideration in calculating net cash inflow.… Read the rest

Significance of Capital Budgeting

The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manager because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come.

Significance of Capital Budgeting Decisions

The significance of capital budgeting can be emphasized taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:

1. Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results.

2. Comparative Study of Alternative Projects. Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated.

3. Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased.… Read the rest

Capital Budgeting- Definition, Nature and Procedure

Meaning of Capital Budgeting

Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture.

The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm.

What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which is supposed to be exhausted within the year concerned.

Nature of Capital Budgeting

Nature of capital budgeting can be explained in brief as under

  • Capital expenditure plans involve a huge investment in fixed assets.
  • Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.
  • Preparation of coital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.

It may be asserted here that decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely.… Read the rest

Importance of Production Planning and Control

For efficient, effective and economical operation in a manufacturing unit of an organization, it is essential to integrate the production planning and control system. Production planning and subsequent production control follow adaption of product design and finalization of a production process. Production planning is an activity that is performed before the actual production process takes place. It involves determining the schedule of production, sequence of operations, economic batch quantities, and also the dispatching priorities for sequencing of jobs. Production control is mainly involved in implementing production schedules and is the corollary to short-term production planning or scheduling. Production control includes initiating production, dispatching items, progressing and then finally reporting back to production planning. In general terms, production planning means planning of the work to be done later and production control refers to working out or the implementation of the plan.

So, the system of production planning and control serves as the nervous system of a plant.  It is a co- ordinating agency which co-ordinate the activities of engineering, purchasing, production, selling and stock control departments.  An efficient system of production planning and control helps in providing better and more economic goods to customers at lower investment.  It is essential in all plants irrespective of their nature and size.

The importance of production planning and control are summarized below:

  • Better Service to Customers: Production planning and control, through proper scheduling and expediting of work, helps in providing better services to customers is terms of better quality of goods at reasonable prices as per promised delivery dates.
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Production Planning and Control

Planning and control are interrelated and interdependent.  Planning is meaningless unless control action is taken to ensure the success of the plan.  Control also provides information feedback which is helpful in modifying the existing plans and in making new plans.  Similarly, control is dependent on planning as the standards of performance are laid down under planning.  Therefore, production and control should be considered an integrated function of planning to ensure the most efficient production and regulation of operations to execute the plans successfully.

Production planning and control may be defined as the direction and coordination of the firm’s material and physical facilities towards the attainment of pre-specified production goals in the most efficient available way. It is the process of planning production in advance of operations, establishing the exact route of each individual item, part or assembly, setting starting and finishing dates for each important item or assembly and finished products, and releasing the necessary orders as well as initiating the required follow up to effectuate the smooth functioning of the enterprise.  Thus, production planning and control involves planning, routing, scheduling, dispatching and expediting to coordinate the movements of materials, machines and manpower as to quantity, quality, time and place.  It is based upon the old adage of “first plan your work and then work your plan”.

Objectives of Production Planning and Control

The main objective of production planning and control is to ensure the coordinated flow of work so that the required number of products are manufactured in the required quantity and of required quality at the required time at optimum efficiency. … Read the rest