Accounting Rate of Return and How to Calculate

Accounting is a numbers game full of ratios and formulas.  Finding the formula is the easy part, understanding the meaning is the important part.

Accounting rate of return is one such formula that requires understanding.  The accounting rate of return (ARR) calculates the return on a capital investment based on the net income generated from that capital investment.  However, there are advantages and disadvantages that need to be understood to properly apply the ratio in your business.

This article will discuss how to calculate the accounting rate of return, the advantages and disadvantages along with some other key information, so keep reading.

How to calculate accounting rate of return (ARR)

The formula is:

Example:

Company XYZ is considering the purchase of a high-end graphical printer at a purchase price of $100,000.  The printer will allow them to produce large scale banners for buildings and open up a new market currently not served by XYZ.  It is anticipated the printer will last 5 years.  XYZ expects to generate $35,000 in profit from this investment.  In order for XYZ to make the investment they need to see a return greater than 5%.

Average Annual Profit - $35,000 / 5 years = $7,000

Average Investment - ($100,000 book value year 1 + $10,000 book value year 5) / 2 = $55,000

ARR - $7,000 / $55,000 = .127 (12.7% return)

Since the estimated 12.7% return is greater than the 5% requirement, XYZ company decides to move forward with the capital investment.

What are the advantages and disadvantages of the accounting rate of return?

Advantages        

1. ARR is relatively easy to compute and understand as it is calculated from accounting information.
2. ARR measures profitability since it is based on accounting profit.
3. ARR is easy to compare when multiple projects are involved.

Disadvantages

1. ARR does not consider the time value of money, nor the timing of profits.

2. ARR does not consider risk in the forecasting estimates.  The longer the investment period the less reliable the accounting rate of return.

3. ARR does not provide an effective comparison when evaluating investments of different sizes.

4. Profits can be easily manipulated due to different depreciation methods.  Other non cash flow items such as bad debts may also affect the results.

Based on the disadvantages it may appear ARR is not an effective evaluation tool.  However, many companies use ARR as a capital budgeting metric because it can be calculated quickly and is easy to compare multiple projects for rate of return.  It becomes one tool in deciding to make an investment or acquisition.

What is the difference between ARR and IRR?

Accounting rate of return (ARR) and internal rate of return (IRR) often get confused.  So, what is the difference between ARR and IRR?  The main difference is ARR is a discounted cash flow method and IRR is a non-discounted cash flow method.

In simple terms, the IRR considers the value of money over time and ARR does not.  

A good IRR exceeds the rate of borrowed funds.  A good ARR exceeds management's internally set limit.