Understanding the Accounting Rate of Return Formula and the Impact of Depreciation

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 an important tool for businesses to evaluate the profitability of potential investment projects.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a financial metric used by businesses to assess the profitability of an investment. It is expressed as a percentage and measures the expected net profit relative to the initial cost of the investment.

The Formula for ARR

The formula for calculating the accounting rate of return is:

ARR = Average Annual Profit / Initial Investment

Where:

• Average Annual Profit is the average net profit generated by the investment project over its useful life.
• Initial Investment is the total cost of the investment project.

How to Calculate ARR

To calculate the accounting rate of return, you need to determine the average annual profit and the initial investment cost. The average annual profit can be calculated by dividing the total net profit generated by the investment project over its useful life by the number of years in its useful life. The initial investment cost includes all costs associated with the project, such as equipment, labor, and materials.

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 that generates a net profit of $20,000 per year for five years. The average annual profit is $20,000, and the initial investment is $100,000. Using the formula, the accounting rate of return would be:

ARR = $20,000 / $100,000 = 0.2 or 20%

Accounting Rate of Return vs. Required Rate of Return

The accounting rate of return is often compared to the required rate of return to assess the profitability of an investment project. The required rate of return is the minimum rate of return that an investor expects to earn to compensate for the risk associated with the investment. If the accounting rate of return is higher than the required rate of return, the investment project is considered profitable.

Advantages and Disadvantages of the ARR

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

• It is easy to calculate and understand, making it accessible to non-financial managers.
• It considers the entire lifespan of the investment project, providing a long-term perspective on profitability.
• It can be used to compare the profitability of different investment projects.

However, the ARR also has some limitations:

• It does not consider the time value of money, as it does not account for the timing of cash flows.
• It does not consider the risk associated with the investment, as it does not incorporate a risk premium.
• It relies on accounting profits, which may be subject to manipulation and do not necessarily reflect cash flows.

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation is an important factor that affects the accounting rate of return. Depreciation refers to the allocation of the cost of an asset over its useful life. When calculating the average annual profit, depreciation expenses are deducted from the net profit. This reduces the average annual profit and, consequently, the accounting rate of return. Therefore, the higher the depreciation expenses, 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 company's internal policies and investment criteria. Some common decision rules include:

• If the accounting rate of return is higher than the required rate of return, the investment project is considered profitable.
• If the accounting rate of return is lower than the required rate of return, the investment project may be rejected.
• If the accounting rate of return is equal to the required rate of return, further analysis is needed to make a decision.

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 the profitability of investment projects. However, there are some key differences between the two:

• The ARR is expressed as a percentage, while the IRR is expressed as a discount rate.
• The ARR considers accounting profits, while the IRR considers cash flows.
• The ARR does not consider the time value of money, while the IRR does.

In summary, the accounting rate of return is a formula that measures the net profit expected on an investment compared to the initial cost. It is a useful tool for businesses to evaluate the profitability of potential investment projects. However, it is important to consider the impact of depreciation on the accounting rate of return, as it can significantly affect the profitability assessment.

The Bottom Line

The accounting rate of return is a valuable financial metric for businesses to assess the profitability of investment projects. By understanding the formula and considering the impact of depreciation, businesses can make more informed investment decisions. However, it is important to remember that the accounting rate of return has its limitations and should be used in conjunction with other financial metrics for a comprehensive evaluation.