Cost-Benefit Analysis: Payback & Accounting Rate of Return

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  • 0:00 Cost-Benefit Analysis Methods
  • 1:02 Payback Period
  • 2:32 Accounting Rate of Return
  • 4:02 One Final Consideration
  • 4:27 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In business, there are a variety of methods used to calculate the expected return on an investment. In this lesson, we'll discuss two common methods: payback period and the accounting rate of return.

Cost-Benefit Analysis Methods

The payback period and the accounting rate of return are two methods that can be used when estimating or projecting the return on an investment. Because they offer different perspectives on an investment return, they can both be useful when discussing the validity of an investment. The payback period expresses how long it takes the benefit of the investment to cover the cost of the investment, while the accounting rate of return is expressed by the annual rate of return generated by the investment.

Before we get to the specifics of calculating payback period and the accounting rate of return, let's set up an example we can use throughout the lesson. Karen has designed a very popular case for smartphones. When she started her business, Karen rented a 3D printer from the local university to manufacture her cases. Now that business is booming, she's considering buying her own 3D printer so she can eliminate the constraints on time and resources, as well as the overhead cost she would be paying the university. The 3D printer she's considering costs $120,000.

Payback Period

First, let's discuss how to calculate the payback period, which will require two pieces of information. First, you need the cost of the investment, which we have. That's the $120,000 that Karen will have to spend to buy the new 3D printer. The second piece of information you need is how much revenue the investment will generate each time period. The time period could be months or years. Just remember, whatever time period you use at this point will determine the time period of your answer.

So, Karen looks at her books and sees that last year, just by selling her single case, she brought in $78,000 in revenue. Being conservative and not wanting to oversell the idea of buying her printer, Karen decides to forecast the same amount of sales for the next few years.

Now we have both pieces of information we need. To get the payback period for the 3D printer, all we need to do is divide the cost of the investment by the revenue produced: $120,000 / $78,000. That equals just over 1.5, and since the $78,000 was an annual number, our answer is 1.5 years. It will take just over 1.5 years for Karen to generate the amount of revenue that equals the cost of the investment.

There's an important note to make here. That payback period doesn't mean the cost of the investment will be paid off in that amount of time. Karen could have received a loan for her printer that she's paying off over five years. But the payback period is a theoretical way to look at the cost of an investment in terms of how much revenue it will produce. It really isn't helpful until you use it to compare between alternate investments.

Accounting Rate of Return

Next, we'll learn to calculate the accounting rate of return, or ARR, which is the annual percent return of an investment. Unlike the payback period, we aren't just looking for the revenue generated by the asset, but also the profit generated by the asset. As a quick reminder, revenue is all the money generated by an asset or company; profit is what is left after all costs are paid for. This can be, and usually is, difficult to estimate, but that's the art of forecasting. So, let's figure out the ARR of Karen's 3D printer.

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