Understanding Accounting Rate of Return (ARR) and How to Calculate It

The accounting rate of return (ARR) is a formula used to measure the net profit or return expected on an investment compared to its initial cost. It is expressed as a percentage and is a widely used method for evaluating the profitability of an investment. In this article, we will explore the definition, formula, calculation, and examples of ARR, as well as its advantages, disadvantages, and decision rules.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a financial metric that measures the profitability of an investment. It calculates the average annual profit generated by an investment as a percentage of its initial cost. ARR is commonly used by businesses and investors to assess the profitability of potential projects or investments.

The Formula for ARR

The formula for calculating accounting rate of return (ARR) is:

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

The average annual profit is calculated by dividing the total profit generated by the investment over its useful life by the number of years in the useful life.

How to Calculate ARR

To calculate the accounting rate of return (ARR), follow these steps:

1. Determine the initial investment cost of the project or investment.
2. Estimate the annual net profit generated by the investment over its useful life.
3. Calculate the average annual profit by dividing the total profit by the number of years in the useful life.
4. Divide the average annual profit by the initial investment cost and multiply by 100% to get the ARR.

Example of the ARR

Let's consider an example to illustrate the calculation of accounting rate of return (ARR). Suppose a company invests $100,000 in a project and expects to generate annual net profits of $20,000 for the next five years. The useful life of the investment is also five years.

Using the formula, we can calculate the ARR as follows:

ARR = ($20,000 / $100,000) x 100% = 20%

Therefore, the accounting rate of return (ARR) for this investment is 20%.

Accounting Rate of Return vs. Required Rate of Return

The accounting rate of return (ARR) is often compared to the required rate of return (RRR) to assess the profitability and viability of an investment. The required rate of return is the minimum rate of return that an investment must generate to be considered acceptable. If the ARR is higher than the RRR, the investment is considered profitable.

Advantages and Disadvantages of the ARR

Like any financial metric, the accounting rate of return (ARR) has its advantages and disadvantages. Some advantages of ARR include:

• Easy to calculate and understand
• Does not require complex discounting or time value of money calculations
• Provides a simple measure of profitability

However, there are also disadvantages to using ARR:

• Does not consider the time value of money
• Does not account for cash flows beyond the payback period
• Relies on estimated future profits and does not account for uncertainties or risks

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation is an accounting method used to allocate the cost of an asset over its useful life. It reduces the book value of the asset over time. Depreciation affects the accounting rate of return (ARR) by reducing the average annual profit, which in turn lowers the ARR. This is because depreciation is considered an expense that reduces the overall profitability of the investment.

What Are the Decision Rules for Accounting Rate of Return?

The decision rules for accounting rate of return (ARR) vary depending on the organization or investor. Generally, a higher ARR is preferred, as it indicates a higher profitability of the investment. However, different organizations may have different minimum ARR requirements based on their investment criteria and risk tolerance. It is important to consider other factors, such as the payback period, cash flows, and risk, when making investment decisions.

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 evaluate the profitability of an investment. However, there are key differences between the two:

• ARR is based on accounting profits, while IRR is based on cash flows.
• ARR does not consider the time value of money, while IRR takes into account the timing and value of cash flows.
• ARR is easier to calculate and understand, while IRR requires more complex calculations.

The Bottom Line

The accounting rate of return (ARR) is a widely used financial metric for evaluating the profitability of an investment. It provides a simple measure of the expected return on investment compared to its initial cost. However, it has its limitations and should be used in conjunction with other financial metrics and factors when making investment decisions.