Accounting Rate of Return (ARR): Definition & Calculation
There are a number of formulas and metrics that companies can use to try and predict the average rate of return of a project or an asset.
One of the easiest ways to figure out profitability is by using the accounting rate of return.
Read on as we take a look at the formula, what it is useful for, and give you an example of an ARR calculation in action.
Table of Contents
- The accounting rate of return (ARR) is a helpful formula when figuring out the annual percentage rate of return of a project.
- ARR is calculated by dividing the initial investment by the average annual profit.
- It is a commonly used formula when looking at multiple projects. This is because it provides the expected rate of return from each individual project.
- A downside to using ARR is that it doesn’t differentiate between investments that yield separate cash flows over the lifetime of a project.
What Is the Accounting Rate of Return (ARR)?
The accounting rate of return (ARR) is a formula that shows the percentage rate of return that is expected on an asset or investment. This is when it is compared to the initial average capital cost of the investment.
The ARR formula calculates the return or ratio that may be anticipated during the lifespan of a project or asset by dividing the asset’s average income by the company’s initial expenditure. The present value of money and cash flows, which are often crucial components of sustaining a firm, are not taken into account by ARR.
What Is the Accounting Rate of Return Useful For?
The accounting rate of return is a capital budgeting indicator that may be used to swiftly and easily determine the profitability of a project. Businesses generally utilize ARR to compare several projects and ascertain the expected rate of return for each one. As well as to assist in making acquisition or average investment decisions.
ARR takes into account any potential yearly costs for the project, including depreciation. Depreciation is a practical accounting practice that allows the cost of a fixed asset to be dispersed or expensed. This is done annually over the course of the item’s useful life. This enables the business to make money off the asset right away, even in the asset’s first year of operation.
What Is the Formula for ARR?
The simple formula that is used to calculate the accounting rate of return is as follows:
How to Calculate ARR
There are three steps to follow when calculating the accounting rate of return:
- The first step is to calculate the annual net profit from the investment in question. This could include revenue minus any annual expenses or costs that are associated with implementing the investment or project.
- Deduct any depreciation expense from the annual revenue to get to the annual net profit. Though this is only if the investment is a fixed asset. Examples would include property, plant, and equipment (PP&E).
- Finally, take the annual net profit and divide it by the initial cost of the investment or asset. The resulting figure of the calculation will be in a decimal format. To show the percentage return as a whole number, take this decimal and multiply it by 100.
Example of the Accounting Rate of Return (ARR)
Let’s say that Company X is thinking about a project that has an initial investment of $25,000. The forecasts were that it would be able to generate revenue for the next five years in total. Using the formula above, here is how the company can calculate the ARR:
- The initial investment is $25,000.
- The expected revenue per year is $7,000.
- The time frame is 5 years.
ARR = 7000 / 25000
ARR = 0.28 x 100
ARR = 28%
The Pros and Cons of Using the Accounting Rate of Return
The pros of using the accounting rate of return include the following:
- It is a straightforward method that determines the return fast using the investment’s earnings.
- Over the course of the project’s economic life, the payback pattern is simple to calculate and comprehend.
- It aids in determining an investment’s return on investment and the project’s present performance.
- This technique makes it possible to compare multiple initiatives with a competitive aspect.
- This approach would be more frequently used by novice investors to evaluate their investment choices.
There are also some disadvantages to using this method. Some examples include:
- This approach ignores cash inflows, taxes, etc., and is only dependent on accounting profitability.
- When an investment is made in a project over time or in installments, this method cannot be used.
- This method’s primary drawback is that it disregards the influence of time. When determining whether a long-term investment will be profitable, the time value of money is crucial.
- This method does not take the lifespan of different investments into account when comparing different projects, which may prevent it from producing the necessary accurate results.
- The outcomes of the same one project when utilizing the return on investment technique are different, and this method overlooks external considerations. Consequently, it is unsuitable for large-scale and long-term projects.
The ARR calculation is a simple and easy-to-use formula. It is a useful tool for evaluating financial performance, as well as personal finance. It also allows managers and investors to calculate the potential profitability of a project or asset. It is a very handy decision-making tool due to the fact that it is so easy to use for financial planning.
However, the formula doesn’t take the cash flow of a project or investment into account. Nor does it take the overall timeline of return or other costs. It should therefore always be used alongside other metrics to get a more rounded and accurate picture.
FAQS on the Accounting Rate of Return
For a project to have a good ARR, then it must be greater than or equal to the required rate of return. If it is less than this rate, it should be rejected.
The main difference is that IRR is a discounted cash flow formula, while ARR is a non-discounted cash flow formula.
The decision rule argues that a firm should choose the project with the highest accounting rate of return when given a choice between several projects to invest in. This is provided that the return is at least equal to the cost of capital.
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