Understanding the Accounting Rate of Return Formula: Definition, Calculation, and Example

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a financial metric used to measure the net profit or return expected from an investment relative to its initial cost. It provides valuable insights for businesses evaluating the profitability of potential projects or investments.

Understanding the Accounting Rate of Return (ARR)

ARR is expressed as a percentage and helps businesses assess the financial viability of a project. By comparing the expected returns to the initial investment, ARR enables decision-makers to determine whether the investment is worthwhile.

The Formula for ARR

The accounting rate of return formula is simple and straightforward:

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

Where:

• Average Annual Profit refers to the expected net profit generated by the investment on an annual basis.
• Initial Investment represents the total amount of money invested in the project.

How to Calculate ARR

Calculating ARR involves two key steps:

1. Determine the average annual profit generated by the investment.
2. Divide the average annual profit by the initial investment and multiply the result by 100.

Example of the ARR

Let's consider an example to better understand how to calculate ARR:

Company XYZ is evaluating a potential investment in a new manufacturing facility. The project requires an initial investment of $500,000. It is estimated that the facility will generate an average annual profit of $100,000. Using the ARR formula:

ARR = ($100,000 / $500,000) x 100 = 20%

Based on the calculated ARR of 20%, Company XYZ can expect a 20% return on its investment in the new manufacturing facility.

Accounting Rate of Return vs. Required Rate of Return

The accounting rate of return should not be confused with the required rate of return (RRR). While ARR focuses on the expected return on an investment, RRR represents the minimum rate of return required by investors or the company to undertake a particular investment. RRR takes into account factors such as the cost of capital, risk, and opportunity cost.

Advantages and Disadvantages of the ARR

Advantages:

• Simple Calculation: ARR is relatively easy to calculate, making it accessible to both financial professionals and non-experts.
• Quick Evaluation: ARR provides a quick assessment of the investment's potential profitability.
• Useful for Internal Decision-Making: ARR is particularly valuable for internal decision-making within a company, helping assess the financial feasibility of projects.

Disadvantages:

• Excludes Time Value of Money: ARR does not consider the time value of money, potentially leading to inaccurate assessments of long-term investments.
• Does Not Account for Cash Flow Timing: ARR fails to account for the timing of cash flows, potentially overlooking projects with uneven cash flow patterns.
• Relies on Accounting Measures: ARR relies on accounting measures, which may not fully capture the economic reality of an investment.

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation impacts the accounting rate of return as it directly affects the average annual profit. When calculating ARR, it is important to consider the depreciation expenses associated with the investment. Depreciation reduces the net profit, which in turn lowers the ARR.

What Are the Decision Rules for Accounting Rate of Return?

The decision to accept or reject an investment based on ARR typically depends on predetermined decision rules. While these rules may vary among organizations, some common guidelines include:

• Accept investments with an ARR greater than a specified target rate.
• Reject investments with an ARR lower than the target rate.
• Consider other financial metrics and qualitative factors in conjunction with ARR to make informed decisions.

What Is the Difference Between ARR and IRR?

ARR and internal rate of return (IRR) are both financial metrics used to assess the profitability of investments, but they differ in several key aspects:

• ARR focuses on the average annual profit relative to the initial investment, while IRR considers the time value of money and the discount rate required for the project's net present value to equal zero.
• IRR takes into account the timing of cash flows, while ARR does not.
• ARR is simpler to calculate and interpret, while IRR requires more complex calculations and may lead to multiple possible rates of return.

The Bottom Line

The accounting rate of return (ARR) is a useful metric for evaluating the potential profitability of investments. By comparing the expected returns to the initial investment, businesses can make informed decisions about project viability. However, it is important to consider the advantages and disadvantages of ARR, as well as other financial metrics and qualitative factors, to make comprehensive investment decisions.