Understanding the Accounting Rate of Return Formula with Examples

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a financial metric that measures the net profit or return expected on an investment compared to the initial cost. It is commonly used by businesses to evaluate the profitability of potential projects or investments. ARR is expressed as a percentage and is calculated using a specific formula.

The Formula for ARR

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

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

The average annual profit is typically derived by dividing the total profit generated over the lifespan of the investment by the number of years.

How to Calculate ARR

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

1. Determine the initial investment cost.
2. Calculate the average annual profit.
3. Divide the average annual profit by the initial investment and multiply by 100%.

Let's walk through an example to illustrate how to calculate ARR.

Example of the ARR

Assume a company invests $100,000 in a project and expects to generate a total profit of $30,000 over a five-year period. To calculate the ARR:

1. Initial Investment: $100,000
2. Average Annual Profit: $30,000 / 5 years = $6,000
3. ARR = ($6,000 / $100,000) x 100% = 6%

The ARR for this investment is 6%, indicating that the company can expect to earn a 6% return on its initial investment.

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 profitability and viability of an investment. The RRR is the minimum rate of return that an investment must generate to justify its risk and opportunity cost. If the ARR is higher than the RRR, the investment is considered profitable. However, if the ARR is lower than the RRR, the investment may not be worthwhile.

Advantages and Disadvantages of the ARR

The accounting rate of return (ARR) has several advantages and disadvantages:

Advantages:

• Simple and easy to calculate.
• Provides a percentage-based measure of profitability.
• Useful for comparing different investment options.

Disadvantages:

• Does not consider the time value of money.
• Relies on accounting profit, which may not reflect actual cash flows.
• Does not account for investment risk or opportunity cost.

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation is an accounting expense that reflects the gradual decrease in value of an asset over time. It is typically deducted from the annual profit when calculating the accounting rate of return (ARR). Depreciation reduces the average annual profit and can lower the ARR, making the investment appear less profitable.

What Are the Decision Rules for Accounting Rate of Return?

The decision rules for accounting rate of return (ARR) vary depending on the business and industry. However, some common guidelines include:

• Accept investments with ARR higher than the required rate of return (RRR).
• Reject investments with ARR lower than the RRR.
• Consider other factors such as risk, cash flows, and strategic importance alongside 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 evaluate investment opportunities. However, there are key differences between the two:

• ARR is a simple percentage-based measure of profitability, while IRR is the discount rate that makes the net present value (NPV) of an investment equal to zero.
• ARR is based on accounting profit, while IRR considers the time value of money and cash flows.
• ARR is easy to calculate but may not provide an accurate representation of investment value, while IRR requires more complex calculations but is considered a more robust measure of profitability.

The Bottom Line:

The accounting rate of return (ARR) is a useful financial metric for evaluating the profitability of potential investments or projects. By calculating the ARR, businesses can assess the expected return on an investment compared to the initial cost. However, it's important to consider the limitations of ARR, such as its disregard for the time value of money and investment risk. When using ARR as a decision-making tool, it's crucial to take into account other factors like cash flows, strategic importance, and required rate of return.