Understanding Accounting Rate of Return (ARR)

Accounting 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.

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How to Calculate 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%.

Calculating the 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 the 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%. While ARR provides a straightforward and easy-to-understand metric, it has its limitations, such as ignoring cash flows and the time value of money.

Accounting Rate of Return Pros and Cons

SmartAsset: Understanding Accounting Rate of Return (ARR)

Managers 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.

The 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 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.

Accounting Rate of Return vs. Required Rate of Return

The Accounting Rate of Return (ARR) and the Required Rate of Return (RRR) are two important financial metrics used in evaluating investment decisions, but they serve different purposes. ARR measures the profitability of an investment by comparing the average annual accounting profit to the initial or average investment cost. It is expressed as a percentage, focusing on the accounting profits rather than cash flows and does not consider the time value of money. ARR is useful for comparing projects based on reported earnings, but it can sometimes be misleading if cash flows or depreciation policies are not aligned with profitability goals.

On the other hand, the Required Rate of Return (RRR) represents the minimum return an investor or firm expects from an investment to justify its risk. It reflects opportunity costs and incorporates factors like the time value of money, risk premiums, and inflation. Unlike ARR, RRR is often used in discounted cash flow models like net present value (NPV) and internal rate of return (IRR) to assess whether a project meets the firm’s investment thresholds. Essentially, while ARR looks at profitability based on accounting figures, RRR focuses on the expected return to compensate for the investment risk and time.

Bottom Line

Accounting 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, the 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 a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can 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.