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Business · Making financial decisions

Understanding business performance

The average rate of return tells a business whether an investment is worth making. Graphs, financial data, market data and marketing data help it understand its performance - as long as it knows the limits of each.

  • 7 key terms
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Teacher resources

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Student handouts

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Last Lesson

Answer from memory before the answers appear.

  • How do you calculate gross profit?

    Sales revenue - cost of sales.

  • How do you calculate net profit?

    Gross profit - other operating expenses and interest.

  • How do you calculate gross profit margin?

    (Gross profit ÷ sales revenue) × 100.

  • What is Bright Bikes' net profit margin?

    14% (£70,000 ÷ £500,000 × 100).

Learning Objectives

  1. 1Calculate and interpret the average rate of return (ARR).
  2. 2Interpret graphs and charts of business data.
  3. 3Explain the use of financial, market and marketing data in decision making.
  4. 4Explain the use and limitations of quantitative and qualitative data.

What Is the Average Rate of Return?

The average rate of return (ARR) shows the average yearly profit from an investment as a percentage of what it cost.

  • Investment

    Spending money now to earn more later - a new machine, a new shop or a new delivery van.

  • Formula

    ARR (%) = (average annual profit ÷ cost of investment) × 100.

  • Average annual profit

    (Total returns - cost of investment) ÷ number of years.

  • What it shows

    The higher the ARR, the better the investment. It can be compared with other investments, or with the interest rate a bank would pay.

Calculating ARR

Three steps: total profit, average annual profit, then ARR.

Bright Bikes buys a £40,000 machine to build bike frames. Over 4 years it expects the machine to bring in total returns of £56,000. Calculate the average rate of return.

  1. 1 Total profit £56,000 - £40,000 = £16,000
  2. 2 Average annual profit £16,000 ÷ 4 years = £4,000
  3. 3 ARR (£4,000 ÷ £40,000) × 100 = 10%

AnswerARR = 10%

Using ARR to Make Decisions

ARR helps a business choose between investments.

  • Compare investments

    Choose the one with the highest ARR.

  • Compare with interest rates

    If the ARR is below what the money would earn in the bank, the investment may not be worth the risk.

  • Set a target

    Some businesses only invest if the ARR is above a set level, such as 10%.

  • Limitations

    ARR relies on forecast returns, which may be wrong, and ignores when the money comes in and non-financial factors.

The Figures Behind the Chart

  • Year 1

    Sales revenue: £380,000. Net profit: £57,000. Net profit margin: 15.0%

  • Year 2

    Sales revenue: £420,000. Net profit: £63,000. Net profit margin: 15.0%

  • Year 3

    Sales revenue: £470,000. Net profit: £56,000. Net profit margin: 11.9%

  • Year 4

    Sales revenue: £500,000. Net profit: £70,000. Net profit margin: 14.0%

Interpreting the Data

What a manager learns from Bright Bikes' figures.

  • Trend

    Revenue grew every year, by £120,000 over four years - the business is winning more customers.

  • Year 3

    Net profit fell and the margin dropped to 11.9% - costs rose faster than sales.

  • Recovery

    In Year 4 the margin recovered to 14%, suggesting costs were brought back under control.

  • The next question

    Data shows what happened, but not always why - the manager needs to find out what caused the Year 3 costs.

Types of Business Data

  • Financial data

    Revenue, costs, profit, margins, cash flow and ARR - how well the business is performing financially.

  • Market data

    The size of the market, how fast it is growing, market share and what competitors are doing.

  • Marketing data

    Results of promotions, website visits, customer feedback, sales by product and by segment.

Quantitative or Qualitative Data?

Quantitative data (numbers)

  • Revenue, profit, margins, market share.
  • Easy to compare over time and with competitors.
  • Easy to present in graphs and charts.
  • But: shows what happened, not why.
  • Can be out of date, or based on forecasts that turn out wrong.

Qualitative data (opinions)

  • Customer reviews, staff feedback, focus groups.
  • Explains why customers and staff behave as they do.
  • Gives ideas for improvement.
  • But: harder to measure and compare.
  • Can be biased, and based on a few people's views.

The Limitations of Financial Information

Financial data is vital, but it never tells the whole story.

  • It looks backwards

    Accounts show what has already happened, not what will happen next.

  • It ignores non-financial factors

    Staff morale, customer satisfaction and reputation do not appear in the accounts.

  • Forecasts may be wrong

    Future figures, such as ARR returns, are estimates.

  • Context matters

    A fall in profit may be due to a one-off cost or a recession, not poor management.

Which Investment?

Bright Bikes has £60,000 to invest. Option A: a new shop costing £60,000, with total returns of £90,000 over 5 years. Option B: a website upgrade costing £60,000, with total returns of £84,000 over 3 years. Calculate the ARR of each, recommend one, and give one non-financial factor Bright Bikes should also consider.

1. Calculate ARR for Option A.

2. Calculate ARR for Option B.

3. Recommend one.

4. Give a non-financial factor.

A good answer shows: Option A ARR 10% (£30,000 ÷ 5 = £6,000; £6,000 ÷ £60,000 × 100). Option B ARR 13.3% (£24,000 ÷ 3 = £8,000; £8,000 ÷ £60,000 × 100). A recommendation using ARR plus a non-financial factor such as staff or customer experience.

Can I...?

  1. 1Explain what ARR shows.
  2. 2Calculate average annual profit.
  3. 3Calculate ARR.
  4. 4Use ARR to compare investments.
  5. 5Interpret a graph of business data.
  6. 6Explain financial, market and marketing data.
  7. 7Explain the limits of quantitative and qualitative data.
  8. 8Explain the limits of financial information.

Summary & Exam Focus

  • ARR = (average annual profit ÷ cost of investment) × 100.
  • Graphs and charts reveal trends that tables hide.
  • Financial, market and marketing data all inform decisions.
  • Quantitative data shows what; qualitative data shows why; financial data has limits.

Exam focus

Calculate the average rate of return on an investment costing £50,000 that returns £70,000 in total over 5 years. (2 marks) (2 marks)

For ARR, subtract the cost first, then divide by the years, then by the cost. For data questions, quote the actual figures from the question in your answer.

Key terms

The vocabulary this lesson expects you to use. Each one is linked from the first place it appears above.

Investment
Spending money now in the hope of earning more in the future.
Average rate of return (ARR)
Average annual profit from an investment as a percentage of its cost.
Financial data
Information about a business's revenue, costs, profit and cash.
Market data
Information about the market, such as its size, growth and market share.
Marketing data
Information about the results of a business's marketing, such as sales and customer feedback.
Quantitative data
Data in the form of numbers.
Qualitative data
Data about opinions, feelings and reasons.

Questions and answers

8 questions set on this lesson, with the mark schemes and model answers open.

1. Exam question Define 1 mark Foundation

Define the term 'average rate of return'.

Mark scheme — 1 mark available

  • Average yearly profit as a % of the cost of investment — 1 mark

Model answer

The average annual profit from an investment, expressed as a percentage of the cost of the investment.

2. Exam question Calculate 2 marks Foundation

A business buys new equipment costing £50,000. It expects total returns of £70,000 over 5 years. Calculate the average rate of return. You are advised to show your working.

Mark scheme — 2 marks available

  • Correct method: ((total returns - cost) ÷ years) ÷ cost × 100 — 1 mark
  • Correct answer: 8% — 1 mark (award 2 marks for the correct answer with no working)

Model answer

Total profit = £70,000 - £50,000 = £20,000. Average annual profit = £20,000 ÷ 5 = £4,000. ARR = (£4,000 ÷ £50,000) × 100 = 8%

3. Exam question Outline 2 marks Foundation

Outline one limitation of using financial information to make business decisions.

Mark scheme — 2 marks available

  • A limitation identified, e.g. backward-looking / ignores non-financial factors / forecasts may be wrong — 1 mark
  • Developed — 1 mark

Model answer

It does not include non-financial factors (1), such as staff morale or customer satisfaction, which can also affect whether a decision succeeds (1).

4. Exam question Explain 3 marks Foundation

Explain one benefit to a business of using qualitative data alongside financial data.

Mark scheme — 3 marks available

  • A benefit identified — 1 mark
  • First linked point of explanation — 1 mark
  • Second linked point of explanation — 1 mark

Model answer

Qualitative data can explain why the financial figures have changed (1). For example, customer reviews might show that sales fell because of poor service rather than high prices (1). This helps managers make the right decision to fix the real problem (1).

5. Exam question Justify 9 marks Stretch

Source: Crest Hotels Ltd has £200,000 to invest. Option 1: Build 10 new rooms, with an ARR of 12%. Option 2: Build a spa, with an ARR of 9%. Customer reviews often mention that the hotel is "often fully booked" and that guests "wish there was a spa". A new hotel with a large spa has just opened nearby. Justify which one of these two options Crest Hotels Ltd should choose.

Mark scheme — 9 marks available

  • AO2 (Application, 3 marks): uses the context - 12% vs 9% ARR, reviews, the new competitor — Level 1-3
  • AO3a (Analysis, 3 marks): chains of reasoning using both financial and qualitative data — Level 1-3
  • AO3b (Evaluation, 3 marks): a justified choice with a supported judgement — Level 1-3

Model answer

Option 1 has the higher ARR of 12%, so on financial grounds it is the better investment. Reviews saying the hotel is "often fully booked" suggest there is demand for more rooms, so the forecast returns are likely to be achieved. However, ARR relies on forecasts and ignores competition: the new hotel with a spa could attract guests away. Option 2 has a lower ARR of 9%, but the qualitative data shows guests want a spa, and it would help Crest compete with the new hotel. This could protect bookings for its existing rooms, a benefit not captured in the spa's ARR. On balance Crest should choose Option 1, because it has the higher ARR and strong evidence of demand, while its hotel is already full. However, this depends on how many guests the new competitor attracts; if bookings start to fall, the spa may become the better choice.

6. Multiple choice 1 mark Foundation

An investment has an average annual profit of £3,000 and cost £30,000. What is its ARR?

  1. A 3%
  2. B 30%
  3. C 10% Correct
  4. D 100%

Why: (£3,000 ÷ £30,000) × 100 = 10%.

7. Multiple choice 1 mark Core

Which of these is qualitative data?

  1. A Sales revenue of £400,000
  2. B Customer reviews Correct
  3. C A net profit margin of 12%
  4. D A market share of 20%

Why: Customer reviews are opinions, so they are qualitative.

8. Multiple choice 1 mark Stretch

What is a limitation of ARR?

  1. A It cannot be calculated as a percentage
  2. B It only uses qualitative data
  3. C It always gives the same answer
  4. D It relies on forecasts that may be wrong Correct

Why: ARR depends on forecast returns, which may turn out to be wrong.