What is the Accounting Rate of Return (ARR)?
Definition: The accounting rate of return (ARR), also called the simple or average rate of return, is an investment formula used to measure the annual earnings or profit an investment is expected to make. In other words, it calculates how much money or return you as an investor will make on your investment.
The accounting rate of return is an accounting ratio that expresses the profit of an organization before interest and taxation, usually for a year, as a percentage of the capital employed at the end of the period. Variants of the measure include using profit after interest and taxation, equity capital employed, and the average of opening and closing capital employed for the period. Although ARR can be used to forecast return on an investment project, discounted cash flow measures are acknowledged to be superior for this purpose.
What Does Accounting Rate of Return Mean?
ARR is an important calculation because it helps investors analyze the risk involved in making an investment and decided whether the earnings are high enough to accept the risk level.
This Most people and companies have some types of investments. Whether the investments are short-term CDs or long-term retirement plans, investments play a big role in Americans’ lives. The only way to tell whether an investment is worthwhile or not is to measure the return or amount of money the investment has made and is expected to make in the future. To do this we must know how to calculate the accounting rate of return.
ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when appraising projects.
The key advantage of ARR is that it is easy to compute and understand. The main disadvantage of ARR is that it disregards the time factor in terms of time value of money or risks for long term investments. The ARR is built on evaluation of profits and it can be easily manipulated with changes in depreciation methods. The ARR can give misleading information when evaluating investments of different size.
Accounting Rate of Return Formula
The accounting rate of return formula is calculated by dividing the income from your investment by the cost of the investment. Usually both of these numbers are either annual numbers or an average of annual numbers. You can also use monthly or even weekly numbers. The time length doesn’t matter.
ARR = Average Annual Profit / Initial Investment
How to Calculate the Accounting Rate of Return – ARR
- Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
- If the investment is a fixed asset such as property, plant, or equipment, subtract any depreciation expense from the annual revenue to achieve the annual net profit.
- Divide the annual net profit by the initial cost of the asset, or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.
Example
A project is being considered that has an initial investment of $250,000 and it’s forecasted to generate revenue for the next five years. Below are the details:
- initial investment: $250,000
- expected revenue per year: $70,000
- time frame: 5 years
- ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
- ARR = .28 or 28% (.28 * 100)
Limitations of Using the Accounting Rate of Return – ARR
The ARR is helpful in determining the annual percentage rate of return of a project. However, the calculation has its limitations.
ARR doesn’t consider the time value of money (TVM). The time value of money is the concept that money available at the present time is worth more than an identical sum in the future due to its potential earning capacity. In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.
The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.
Also, ARR does not take into account the impact of cash flow timing. Let’s say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn’t yield any revenue until the fourth and fifth year. The investor would need to be able to withstand the first three years without any positive cash flow from the project. The ARR calculation would not factor in the lack of cash flow in the first three years.
Advantages and Disadvantages of the Accounting Rate of Return (ARR)
Advantages:
- Like payback period, this method of investment appraisal is easy to calculate.
- It recognizes the profitability factor of investment.
Disadvantages:
- It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher.
- It can be calculated in different ways. Thus there is problem of consistency.
- It uses accounting income rather than cash flow information. Thus it is not suitable for projects which having high maintenance costs because their viability also depends upon timely cash inflows.
In short, the accounting rate of return is not by any means a perfect method for evaluating a capital project, and so should be used (if at all) only in concert with a number of other evaluation tools. In particular, you should find another tool to address the time value of money and the risk associated with a long-term investment, since this tool does not provide for it. Possible replacement measurements are net present value, the internal rate of return, and constraint analysis. This measure would be of the most use for reviewing short-term investments where the impact of the time value of money is reduced.