Rate of return from an accounting perspective
Written byCFI Team
Updated March 14, 2023
What is ARR – Accounting Rate of Return?
Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in an asset (a project, an acquisition, etc.) based on the future net earnings expected compared to the capital cost.
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ARR Formula
The formula for ARR is:
ARR = Average Annual Profit / Average Investment
Where:
- Average Annual Profit = Total profit over Investment Period / Number of Years
- Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
Components of ARR
If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar invested per year.
In terms of decision making, if the ARR is equal to or greater than a company’s required rate of return, the project is acceptable because the company will earn at least the required rate of return.
If the ARR is less than the required rate of return, the project should be rejected. Therefore, the higher the ARR, the more profitable the company will become.
Read more about hurdle rates.
ARR – Example 1
XYZ Company is looking to invest in some new machinery to replace its current malfunctioning one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.
| Step 1: Calculate Average Annual Profit | ||
| Inflows, Years 1-12 | ||
| (200,000*12) | $2,400,000 | |
| Less: Annual Expenses | ||
| (50,000*12) | -$600,000 | |
| Less: Depreciation | -$420,000 | |
| Total Profit | $1,380,000 | |
| Average Annual Profit | ||
| (1,380,000/12) | $115,000 | |
Step 2: Calculate Average Investment | ||
| Average Investment | ||
| ($420,000 + $0)/2 = $210,000 | ||
Step 3: Use ARR Formula | ||
| ARR = $115,000/$210,000 = 54.76% | ||
Therefore, this means that for every dollar invested, the investment will return a profit of about 54.76 cents.
ARR – Example 2
XYZ Company is considering investing in a project that requires an initial investment of $100,000 for some machinery. There will be net inflows of $20,000 for the first two years, $10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage value of $25,000.
| Step 1: Calculate Average Annual Profit | ||
| Inflows, Years 1 & 2 | ||
| (20,000*2) | $40,000 | |
| Inflows, Years 3 & 4 | ||
| (10,000*2) | $20,000 | |
| Inflow, Year 5 | $30,000 | |
| Less: Depreciation | ||
| (100,000-25,000) | -$75,000 | |
| Total Profit | $15,000 | |
| Average Annual Profit | ||
| (15,000/5) | $3,000 | |
Step 2: Calculate Average Investment | ||
| Average Investment | ||
| ($100,000 + $25,000) / 2 = $62,500 | ||
Step 3: Use ARR Formula | ||
| ARR = $3,000/$62,500 = 4.8% | ||
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Limitations to Accounting Rate of Return
Although ARR is an effective tool to grasp a general idea of whether to proceed with a project in terms of its profitability, there are several limitations to this approach:
- It ignores the time value of money. It assumes accounting income in future years has the same value as accounting income in the current year. A better metric that considers the present value of all future cash flows is NPVand Internal Rate of Return (IRR).
- It does not consider the increased risk of long-term projects and the increased variability associated with prolonged projects.
- It is only a financial guide for projects. Sometimes projects are proposed and implemented to enhance other important variables such as safety, environmental concerns, or governmental regulations.
- It is not an ideal comparative metric between projects because different projects have different variables such as time and other non-financial factors to consider.
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Additional Resources
We hope the above article has been a helpful guide to understanding the Accounting Rate of Return, the formula, and how you can use it in your career. To keep learning and advancing your career these additional CFI resources will be helpful:
