Understanding Accounting Rate of Return Calculation with Examples

The accounting rate of return (ARR) is a financial metric that measures the net profit or return expected on an investment compared to its initial cost. It is a useful tool for businesses and investors to evaluate the profitability of a project or investment.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that calculates the annual percentage rate of return on an investment. It is a popular metric used in capital budgeting and financial analysis to assess the profitability of an investment.

The Formula for ARR

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

ARR = Average Annual Profit / Initial Investment

Where:

• Average Annual Profit is the average net profit generated by the investment over its useful life.
• Initial Investment is the total cost of the investment, including both the initial purchase price and any additional costs.

How to Calculate ARR

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

1. Determine the average annual profit generated by the investment. This can be calculated by taking the total net profit generated over the investment's useful life and dividing it by the number of years.
2. Calculate the initial investment by adding up all the costs associated with the investment.
3. Divide the average annual profit by the initial investment to get the accounting rate of return (ARR) as a percentage.

Example of the ARR

Let's consider an example to illustrate the calculation of the accounting rate of return (ARR). Suppose a company invests $100,000 in a project and expects to generate an average annual profit of $20,000 over the project's useful life of 5 years.

To calculate the ARR, we divide the average annual profit ($20,000) by the initial investment ($100,000) and multiply by 100 to convert it to a percentage:

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

Based on this calculation, the accounting rate of return (ARR) for the project 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 feasibility and profitability of an investment. The required rate of return is the minimum rate of return that an investor or company expects from an investment to justify the risk and opportunity cost.

Advantages and Disadvantages of the ARR

The accounting rate of return (ARR) has both advantages and disadvantages as a financial metric:

Advantages:

• Simple and easy to calculate.
• Uses accounting data readily available.
• Provides a percentage figure for easy comparison.

Disadvantages:

• Does not consider the time value of money.
• Relies on accounting profit rather than cash flows.
• Does not consider the project's duration or risk.
• Does not account for the reinvestment of profits.

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 affects the accounting rate of return (ARR) by reducing the net profit used in the calculation. Depreciation expense is subtracted from the net profit to determine the average annual profit.

What Are the Decision Rules for Accounting Rate of Return?

The decision rules for the accounting rate of return (ARR) vary depending on the industry and company's specific requirements. However, some general guidelines include:

• Accept projects with a higher ARR than the company's minimum required rate of return (RRR).
• Reject projects with a negative ARR or an ARR lower than the RRR.
• Consider other factors such as cash flows, risk, and strategic alignment in addition to the 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. The key difference between ARR and IRR is that the ARR measures the average annual return as a percentage of the initial investment, while the IRR is the discount rate that makes the net present value (NPV) of an investment equal to zero.

The Bottom Line

The accounting rate of return (ARR) is a useful tool for businesses and investors to evaluate the profitability of an investment. By calculating the ARR, stakeholders can assess the expected return on investment compared to its initial cost. However, it is important to consider the limitations and drawbacks of the ARR, such as its failure to account for the time value of money and cash flows. It is advisable to use the ARR in conjunction with other financial metrics and consider additional factors when making investment decisions.