Average Rate of Return

Costs, profit and return

Before the numbers make sense you need the money words. Fixed costs stay the same whatever the output, such as rent and salaries. Variable costs rise as output rises, such as raw materials. Together they make the total costs. Revenue is the money coming in from sales, and profit is revenue minus total costs, while a loss is when costs are greater than revenue. Businesses also weigh up investments, such as new machinery or a vehicle, using the average rate of return. This turns the profit an investment earns into a percentage of what it cost, so two projects can be compared fairly. You work out the average annual profit, divide it by the initial cost, and multiply by 100. This module covers the terms and how to calculate the return.

Money words

Learn these before you calculate anything, and keep profit and the return clearly apart.

Fixed against variable costs

The first skill is telling the two kinds of cost apart, because only one changes with how much is made.

How to work out the return

Take the calculation in three clear moves. First find the average annual profit by sharing the total profit evenly across the years the investment lasts. Next set that yearly figure against what the investment cost by dividing one by the other. Finally turn it into a percentage by multiplying by 100, so it can be lined up against another project or a bank rate. Always show each move, and pick the project whose percentage is higher, other things being equal.

Match the term to its meaning

Which is a fixed cost?

A bakery lists its monthly costs. Which of these is a fixed cost?

• The rent on the shop, which is the same every month.
• The flour, which costs more when more bread is baked.
• The packaging, one bag per loaf sold.
• The extra ingredients for a bigger batch.

Working out the return

Select the TWO steps used to calculate the average rate of return.

• Find the average annual profit of the investment
• Divide that by the initial cost, then multiply by 100
• Ignore what the investment cost
• Use only the profit from a single year

Average rate of return

A project costs 2000 pounds and earns an average annual profit of 300 pounds. The average rate of return is the average annual profit divided by the cost, times 100. What is the return, as a value in per cent?

Order the return calculation

Put the steps of calculating the average rate of return in order, earliest first.

• Add up the total profit over all the years
• Divide by the number of years for the average annual profit
• Divide that by the initial cost of the investment
• Multiply by 100 to get the return in per cent

Complete the facts

A cost that stays the same whatever the output is a _____ cost. A cost that rises as output rises is a _____ cost. The money coming in from sales is _____. The average annual profit shown as a percentage of the cost is the average rate of _____.

Match the term to its calculation

Spot the true finance facts

Tap the TWO statements that are true about these financial terms.

• Fixed costs stay the same whatever the output
• The average rate of return is shown as a percentage
• Variable costs never change with output
• Profit is revenue added to total costs

Judge the investment

Read each case and choose the best response, with a reason.

• Project A has an average rate of return of 12 per cent and Project B has 8 per cent, for the same cost and risk. Which should the firm choose?
• A student divides the total profit by the cost but forgets to find the average annual profit first. What have they done wrong?
• A student gives only the final percentage with no working shown. How should the answer improve?

Explain the average rate of return

A firm is choosing between two machines, each costing the same. Explain the financial terms involved and how the average rate of return would help it choose.

• Explain the difference between fixed and variable costs
• Explain what revenue and profit mean
• Explain how the average rate of return is calculated, with the steps
• Explain how the return lets the firm compare the two machines
• Finish with a judgement on why showing the full working matters