Understanding Accounting Rate of Return: Definition, Calculation, and Examples

The accounting rate of return (ARR) is an important financial metric that helps investors and business owners assess the profitability of an investment. It measures the net profit or return expected on an investment compared to the initial cost. In this blog post, we will explore the definition, calculation, and examples of the accounting rate of return.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that measures the profitability of an investment by comparing the expected net profit to the initial cost of the investment. It is expressed as a percentage and is often used as a decision-making tool for evaluating investment opportunities.

The Formula for ARR

The formula for calculating the accounting rate of return 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.

How to Calculate ARR

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

1. Determine the initial investment cost.
2. Estimate the annual net profit for each year of the investment's useful life.
3. Calculate the average annual profit by dividing the total net profit by the number of years.
4. Apply the formula: ARR = (Average Annual Profit / Initial Investment) x 100

Example of the ARR

Let's consider an example to illustrate how the accounting rate of return is calculated. Suppose a company invests $100,000 in a project and expects to generate annual net profits of $20,000 for five years. The total net profit over the investment's useful life would be $100,000, and the average annual profit would be $20,000. Applying the ARR formula:

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

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

Advantages and Disadvantages of the ARR

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

• Simple and easy to calculate
• Helps assess the profitability of an investment
• Provides a percentage figure for easy comparison

However, the accounting rate of return also has some disadvantages, such as:

• Does not consider the time value of money
• Relies on estimated future profits
• Does not account for the risk associated with the investment

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation is an important factor that affects the accounting rate of return. Depreciation is the allocation of the cost of an asset over its useful life. It reduces the net profit and, consequently, the accounting rate of return. The higher the depreciation expense, the lower the accounting rate of return.

What Are the Decision Rules for Accounting Rate of Return?

The decision rules for the accounting rate of return depend on the specific circumstances and requirements of the investor or business owner. However, some general guidelines include:

• If the ARR is higher than the required rate of return, the investment may be considered favorable.
• If the ARR is lower than the required rate of return, the investment may be considered unfavorable.
• Other factors, such as the risk associated with the investment and the availability of alternative investment opportunities, should also be considered.

What Is the Difference Between ARR and IRR?

The accounting rate of return (ARR) and the internal rate of return (IRR) are both financial metrics used to assess investment profitability. The main difference between the two is that the ARR focuses on the average annual profit as a percentage of the initial investment, while the IRR considers the time value of money and calculates the discount rate at which the net present value (NPV) of an investment equals zero.

The Bottom Line

The accounting rate of return (ARR) is a valuable financial metric that helps investors and business owners evaluate the profitability of an investment. By understanding the definition, calculation, and examples of the ARR, individuals can make more informed investment decisions. However, it is important to consider the advantages, disadvantages, and other factors before solely relying on the ARR as a decision-making tool.