Menu burger Close thin Facebook Twitter Google plus Linked in Reddit Email
Loading
Tap on the profile icon to edit
your financial details.

Accounting paperwork on a deskAccounting rate of return is a tool used to decide whether it makes financial sense to proceed with a costly equipment purchase, acquisition of another company or another sizable business investment. It is the average annual net income the investment will produce, divided by its average capital cost. If the result is more than the minimum rate of return the business requires, that is an indication the investment may be worthwhile. If the accounting rate of return is below the benchmark, the investment won’t be considered.

Calculating Accounting Rate of Return

To calculate the accounting rate of return for an investment, divide its average annual profit by its average annual investment cost. The result is expressed as a percentage. For example, if a new machine being considered for purchase will have an average investment cost of $100,000 and generate an average annual profit increase of $20,000, the accounting rate of return will be 20%.

Average annual profit increase $20,000 / Average investment cost $100,000 = 0.20

The ARR on this investment is 0.20 x 100 or 20%.

To calculate accounting rate of return requires three steps, figuring the average annual profit increase, then the average investment cost and then apply the ARR formula.

To arrive at a figure for the average annual profit increase, analysts project the estimated increase in annual revenues the investment will provide over its useful life. Then they subtract the increase in annual costs, including non-cash charges for depreciation.

To get average investment cost, analysts take the initial book value of the investment plus the book value at the end of its life and divide that sum by two.

For example, say a company is considering the purchase of a new machine that will cost $100,000. It will generate a total of $150,000 in additional net profits over a period of 10 years. After that time, it will be at the end of its useful life and have $10,000 in salvage (or residual) value.

First, calculate average annual profit:

Additional profits:  $150,000

Minus depreciation (purchase cost minus salvage value): $90,000

Total profits after depreciation: $60,000

Average annual profit over 10 years: $6,000

Second, calculate average investment costs:

Average investment ($100,000 first year book value plus $10,000 last year book value) / 2 = $55,000

Now apply the accounting rate of return formula:

$6,000 / $55,000 = 0.109

The ARR for this investment would be 0.109 x 100 or 10.9%.

ARR Pros and Cons

New conveyor line at dairy plantManagers can decide whether to go ahead with an investment by comparing the accounting rate of return with the minimum rate of return the business requires to justify investments. For example, a business may require investments to return at least 15%. In the above case, the purchase of the new machine would not be justified because the 10.9% accounting rate of return is less than the 15% minimum required return.

Accounting rate of return is also sometimes called the simple rate of return or the average rate of return. Accounting rate of return can be used to screen individual projects, but it is not well-suited to comparing investment opportunities.  One reason is that it does not consider the time value of money. Different investments may involve different time periods, which can change the overall value proposition.

Unlike other widely used return measures, such as net present value and internal rate of return, accounting rate of return does not consider the cash flow an investment will generate. Instead, it focuses on the net operating income the investment will provide. This can be helpful because net income is what many investors and lenders consider when selecting an investment or considering a loan. However, cash flow is arguably a more important concern for the people actually running the business. So accounting rate of return is not necessarily the only or best way to evaluate a proposed investment.

The Bottom Line

Factory owner at workAccounting rate of return is a simple and quick way to examine a proposed investment to see if it meets a business’s standard for minimum required return. Rather than looking at cash flows, as other investment evaluation tools like net present value and internal rate of return do, accounting rate of return examines net income. However, among its limits are the way it fails to account for the time value of money.

Tips for Evaluating Capital Investments

  • Consider working with an experienced financial advisor if you are evaluating a proposed investment. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • If the ARR calculation of a proposed capital investment or acquisition looks weak, it might make more sense to outsource. Outsourcing is a complicated issue so it’s good to have grasped the basic arguments for and against outsourcing before you take that alternative step.

Photo credit: ©iStock.com/cnythzl, ©iStock.com/andrey shalari, ©iStock.com/FG Trade

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
Was this content helpful?
Thanks for your input!