Accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment’s cost. ARR calculation can be helpful for a business to determine whether going ahead with a particular investment is the right move.
How to calculate ARR?
The investing entity has to first work out the annual net profit of the proposed investment. Net profit is the money remaining after factoring in all expenses. It’s calculated as Total Revenue – Total Expenses i
Total expenses include tax and depreciation if the investment is a fixed asset.
Now, you have to divide the annual net profit by the initial cost of the asset or investment. The calculation will show a decimal, so multiply the result by 100 to see the percentage return.
ARR formula is as follows:
ARR = average annual profit / average investment
Here’s an example of how to use the Accounting Rate of Return formula in the real world. A Company wants to invest in a new set of machinery for the business. The machinery costs Rs.1500000 and would increase the company’s annual revenue by Rs.300, 000, as well as the company’s annual expenses on the machinery are Rs.10, 000. The machinery is estimated to have a useful life of 20 years, with no salvage value. So, the ARR calculation is as follows:
Average annual profit = 300,000 – 10,000 = 290,000
Depreciation expense = 1500000 / 20 = 75000
True average annual profit = 290,000 – 75000 = 215000
ARR = 215000/ 1500000 = 0.14333 = 14.33%
Here, the company will receive a return of 14.33% which is relatively good if it is better than the company’s other options and it may go ahead with the investment.
Advantages of using Accounting rate of return:
- The ARR concept is a familiar concept to return on investment (ROI), or return on capital employed.
- It is easier to calculate and simple to understand like payback period.
- It considers accounting concept of profit for calculating rate of return. The accounting profit can be readily calculated from the accounting records.
- Total profits or savings over the entire period of economic life of the project is estimated under ARR method which gives clear picture of profitability from the project.
- It is a simple capital budgeting technique and is widely used to provide a guide to how attractive an investment project is.
The drawbacks of using Accounting rate of return:
- This method is based on profits rather than cash flow. Therefore it can be affected by non-cash items such as the depreciation and bad debts when calculating profits.
- The change of methods for depreciation can lead to different outcomes.
- This technique does not adjust for the risk to longer term forecasts.
- This method ignores time factor. The profits are earned as a 14.33% rate of return in 20 years may be considered to be better than 8% rate of return for 5 years under ARR method. This is not proper because longer the term of the project, greater is the risk involved.
- This method does not consider the external factors which are also affecting the profitability of the project.