Accounting Rate of Return

What Is Accounting Rate of Return (ARR)?

Accounting Rate of Return (ARR) measures the profit realized from a financial investment during the period such an investment is expected to be profitable. Thus, the accounting Rate of Return is a return factor used to determine the profit from a particular investment. 

The ARR provides an idea of how much profit an enterprise will earn from any given investment. It helps assess whether particular investments are worthwhile or having too low a return can harm a specific investment’s potential profits. A high ARR indicates significant potential for high returns in the future. It also implies that you are likely to make a profit from any investment.

Accounting Rate of Return (ARR) is one of the critical factors considered while investing in a company’s capital growth. This factor provides an idea of the expected profitability of new projects or the increase in profits achieved over time. In addition, ARR can be used to compare two or more investments in the same company so that management can decide if they should devote more resources to one over the other.

How to Calculate Accounting Rate of Return (Formula Included)

The Accounting Rate can be calculated using the below formula

ARR = Average Annual Profit / Initial Investment

Where,

The AVERAGE annual profit is the average amount of profit that a business could earn the Initial investment is the total amount of money required to support that profit.

  1. To find the rate of return on a project, calculate the annual net profit from the investment by subtracting all costs or expenses incurred directly in implementing the project or investment.
  2. For fixed assets, subtract the depreciation from the revenue to calculate the annual net profit.
  1. To calculate the accounting rate of return, divide the annual net profit by the initial cost of a business asset. Multiply the result by 100 to show the percentage rate as a whole number.

What Does ARR Tell You?

The accounting rate of return – commonly abbreviated ARR – is a simple but powerful metric that measures an investment’s profitability. It’s most useful for comparing different projects or for making investment decisions.

If you think it’d be useful to calculate the profitability of your decisions like a business does, then the accounting rate of return is a metric you should use. Accounting Rate of Return is designed to give you an immediate view of a project’s profitability.

To determine whether a project’s rate of return (ARR) is acceptable in financial terms, you must consider any possible annual expenses, including depreciation (or amortization), associated with the project.

Depreciation is a convention that is helpful for accountants in describing the cost of a fixed asset over its useful life. Depreciation expense is the allocation over time of the cost of bringing an asset to its place of business and the asset’s maintenance, repair, and replacement.

This figure represents the net return, or profit, from the project. This provides added transparency and increases a company’s credibility as a business, and enables them to gain more investors in the future.

How to Use ARR

For example, a company considers a project with an initial investment of $250,000 and forecasts that it can generate revenue for the next five years. The company could calculate the ARR as follows:

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 = 0.28 or 28% (0.28 * 100)

The Difference Between ARR and RRR

The ARR is the actual annual return on an investment; it is the amount of profit generated over the lifetime of the investment if invested at the stated rate of return. At the same time, the RRR is the amount of profit required to pay off an initial debt load plus interest or principal over a given period.

The Annual Rate of Return (ARR) is calculated based on what investment would have generated were it sold today, with all dividends paid out. The RRR, on the other hand, takes into account the inflation-protected stock market capitalization and long-term expected earnings, so it’s more relevant in representing a guaranteed profit over time.

The required rate of return (RRR) can vary between investors as they each have different tolerance for risk. For example, a risk-averse investor is likely to require a higher return than a more aggressive investor to compensate for any risk from the investment. It’s important to utilize multiple financial metrics, including the annualized return and required rate of return, to determine if an investment would be worthwhile based on your level of risk tolerance.

Limitations of Using ARR

  • It ignores some costs as well as income taxes. Also, you will almost always be charged interest for money that is not earned by the business.
  • In addition, some companies claim the accounting rate of return is an unfair comparison because it does not take into account what a company pays for risks such as employee injury or death and damage to property.
  • It deals with returns as if they are independent events, ignoring the costs of time involved in creating and carrying out the measured activity. This has severe implications for decision-making because we cannot compare the benefits we obtain from an activity with the costs incurred by that activity.

How to Calculate Accounting Rate of Return in Excel?

The ARR calculator in an Excel spreadsheet can help you track your business and finance development more comprehensively. In A1, write ‘Year.’

  1. In C1-G1, write 1, 2, 3, 4, 5 (assume a five-year project).
  2. In A2, mention  ‘Net Income.’
  3. In C2-G2, mention the net annual income for each year.
  4. In A3, mention ‘Initial Investment.’
  5. In B3, mention the initial investment for the project.
  6. In A4, mention ‘Salvage Value.’
  7. In B4, mention the salvage value, if any.
  8. In A5, mention ‘ARR’.
  9. In B5, mention =AVERAGE(C2:G2)/AVERAGE(B3:B4).
  10.  To calculate ARR, press enter.
  11. B5 cell will reflect the ARR.

Note that you have to change the values as per your project estimations. For example, the project can take more than five years. This simple method allows you to calculate your Accounting Rate of Return in Excel. It is a useful way to evaluate a project and determine if it is successful or not.

Components of ARR

If the annualized return rate is equal to or greater than 5%, this means that the investment will earn five cents for every dollar invested over a year.

If a project’s annual return rate is greater than or equal to the required rate of return, they accept that the project will return at least the rate of return. 

If the project’s return is less than your required rate of return, reject the project. Therefore, higher rates of return mean more profitability.

ARR – Example 1

ABC Company invests in some new machinery to replace its current malfunctioning one. The new machine costing $420,000 would increase annual revenue by $200,000. Thereby increasing the annual expenses by $50,000. The machine is excepted to have a life of 12 years and zero salvage value.

 1. Calculate Average Annual Profit

 Years 1-12

(200,000*12) $2,400,000

Subtract the Annual Expenses

(50,000*12) -$600,000

Subtract the Depreciation -$420,000

Total Profit $1,380,000

Average Annual Profit

(1,380,000/12) $115,000

 2. Calculate Average Investment

Average Investment

($420,000 + $0)/2 = $210,000 

3. Calculate ARR 

ARR = $115,000/$210,000 = 54.76%

The company will earn a profit of 54.76% for every dollar invested.

Example 2

ABC Company considers investing in a project that requires an initial investment of $100,000 for machinery. There will be total inflows of $20,000 for the first two years initially and $10,000 in the third and fourth year, and $30,000 in the fifth year. Also, the machine has a salvage value of $25,000.

1. Calculate Average Annual Profit

 Years 1st & 2nd

(20,000*2) $40,000

Inflows in 3rd & 4th year

(10,000*2) $20,000

Inflow for year 5th $30,000

Minus Depreciation

(100,000-25,000) -$75,000

Total Profit $15,000

Average Annual Profit

(15,000/5) $3,000

2. Calculate Average Investment

Average Investment

($100,000 + $25,000) / 2 = $62,500

 3. Using ARR Formula

ARR = $3,000/$62,500 = 4.8%