Understanding the Accounting Rate of Return Formula: A Comprehensive Guide

The accounting rate of return (ARR) is a crucial metric used by businesses to evaluate the profitability of an investment. It provides insights into the expected net profit or return in comparison to the initial cost. By understanding the accounting rate of return formula and its significance, businesses can make informed decisions regarding their investments.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a financial metric used to measure the profitability of an investment. It indicates the percentage of return or profit expected in relation to the initial investment cost. ARR is expressed as a percentage, making it easier to compare different investment opportunities.

The Formula for ARR

The accounting rate of return (ARR) formula is relatively simple:

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

By dividing the average annual profit by the initial investment and multiplying it by 100%, businesses can calculate the accounting rate of return.

How to Calculate ARR

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

1. Determine the average annual profit from the investment.
2. Calculate the initial investment cost.
3. Divide the average annual profit by the initial investment cost.
4. Multiply the result by 100% to obtain the ARR.

Example of the ARR

Let's consider an example to illustrate the calculation of the accounting rate of return (ARR). A company invests $50,000 in a project and expects an average annual profit of $10,000 over five years. Using the formula, we can calculate the ARR as follows:

ARR = ($10,000 / $50,000) x 100% = 20%

In this example, the accounting rate of return (ARR) is 20%, indicating a 20% return on the initial investment.

Accounting Rate of Return vs. Required Rate of Return

While the accounting rate of return (ARR) focuses on the expected profitability of an investment, the required rate of return considers the minimum return necessary to justify the investment. The required rate of return takes into account factors such as the cost of capital and the risk associated with the investment.

Advantages and Disadvantages of the ARR

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

Advantages

• Simple Calculation: The ARR formula is straightforward and easy to calculate, making it accessible to businesses of all sizes.
• Percentage Representation: ARR is expressed as a percentage, allowing for convenient comparison between different investment opportunities.

Disadvantages

• Excludes Time Value of Money: The ARR formula does not consider the time value of money, meaning it does not account for the potential impact of inflation and the value of money over time.
• Doesn't Consider Cash Flows: ARR focuses on the average annual profit and does not consider the timing or magnitude of cash flows, potentially overlooking crucial financial factors.

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation is a critical factor that can impact the accounting rate of return (ARR). Depreciation refers to the systematic allocation of the cost of an asset over its useful life. When calculating ARR, businesses should consider the depreciation expense associated with the investment to obtain a more accurate assessment of profitability.

What Are the Decision Rules for Accounting Rate of Return?

When using the accounting rate of return (ARR) as a decision-making tool, businesses often establish decision rules to guide their investment choices. Some common decision rules include:

• Accepting Investments with ARR Higher Than a Certain Threshold: Businesses may set a minimum acceptable ARR as a criterion for accepting investment projects.
• Comparing ARR with the Required Rate of Return: By comparing the ARR with the required rate of return, businesses can assess whether an investment is financially viable.

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 investment opportunities, but they differ in their approach. While ARR focuses on profitability and uses average annual profit, IRR considers the time value of money and calculates the discount rate that equates the present value of cash inflows and outflows.

The Bottom Line

The accounting rate of return (ARR) is a valuable tool for businesses to assess the profitability of investment opportunities. By understanding the ARR formula, calculating ARR accurately, and considering its advantages and disadvantages, businesses can make well-informed decisions regarding their investments.