How to Calculate Accounting Rate of Return in Excel

Are you looking to calculate the accounting rate of return (ARR) for your investment in Excel? In this article, we will explore the key formulas and steps to calculate the ARR in Excel. We will also discuss the concept of the ARR and its advantages and disadvantages.

Table of Contents

• What Is the Accounting Rate of Return?
• Understanding the Accounting Rate of Return (ARR)
• The Formula for ARR
• How to Calculate ARR
• Example of the ARR
• Accounting Rate of Return vs. Required Rate of Return
• Advantages and Disadvantages of the ARR
• How Does Depreciation Affect the Accounting Rate of Return?
• What Are the Decision Rules for Accounting Rate of Return?
• What Is the Difference Between ARR and IRR?
• The Bottom Line

What Is the Accounting Rate of Return?

The accounting rate of return (ARR) is a formula that measures the net profit or return expected on an investment compared to the initial cost. It is a financial metric used by businesses and investors to assess the profitability of an investment.

Understanding the Accounting Rate of Return (ARR)

The ARR takes into account the net profit generated by an investment and divides it by the initial cost of the investment. It provides a percentage value that represents the average annual return over the investment's lifespan.

The Formula for ARR

The formula for calculating the accounting rate of return is:

ARR = (Average Annual Profit / Initial Investment) x 100%

How to Calculate ARR

To calculate the ARR in Excel, follow these steps:

1. Identify the net profit generated by the investment over its lifespan.
2. Determine the initial cost of the investment.
3. Calculate the average annual profit by dividing the net profit by the lifespan of the investment.
4. Divide the average annual profit by the initial investment.
5. Multiply the result by 100% to get the ARR as a percentage.

Example of the ARR

Let's consider an example to understand how to calculate the ARR in Excel. Suppose you invest $10,000 in a business venture, and over a period of 5 years, the net profit generated is $3,000 per year. The initial cost of the investment is $10,000.

To calculate the ARR:

1. The net profit is $3,000 per year.
2. The initial investment is $10,000.
3. The average annual profit is $3,000 / 5 = $600.
4. The ARR is ($600 / $10,000) x 100% = 6%.

Accounting Rate of Return vs. Required Rate of Return

The accounting rate of return (ARR) is different from the required rate of return (RRR). The ARR focuses on the profitability of an investment, while the RRR represents the minimum return required by an investor or company to consider an investment worthwhile.

Advantages and Disadvantages of the ARR

The accounting rate of return has several advantages and disadvantages:

Advantages:

• Simple and easy to calculate.
• Uses accounting data readily available.
• Helps assess the profitability of an investment.

Disadvantages:

• Does not consider the time value of money.
• Does not account for the entire cash flow of an investment.
• Relies on accounting data, which may be subject to manipulation.

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation affects the accounting rate of return by reducing the net profit generated by an investment. Depreciation is an accounting method that allocates the cost of an asset over its useful life. As the depreciation expense increases, the net profit decreases, resulting in a lower accounting rate of return.

What Are the Decision Rules for Accounting Rate of Return?

The decision rules for the accounting rate of return vary depending on the company's or investor's requirements. Some common decision rules include:

• Accept an investment if the ARR is higher than the required rate of return.
• Reject an investment if the ARR is lower than the required rate of return.
• Compare the ARR of multiple investment options and choose the one with the highest ARR.

What Is the Difference Between ARR and IRR?

The accounting rate of return (ARR) and internal rate of return (IRR) are both financial metrics used to assess the profitability of an investment. However, there are key differences between them:

• The ARR uses accounting data, while the IRR considers the time value of money.
• The ARR provides a percentage return, while the IRR provides a discount rate.
• The ARR is easier to calculate, while the IRR requires trial and error or the use of specialized software.

The Bottom Line

The accounting rate of return (ARR) is a useful metric for assessing the profitability of an investment. By calculating the ARR in Excel, you can make informed investment decisions and evaluate the potential returns of different investment options. However, it is important to consider the limitations of the ARR and use it in conjunction with other financial metrics to make well-informed investment decisions.