The Accounting Rate of Return (ARR) is a capital budgeting method used to determine the profitability of an investment. It is also known as the Average Rate of Return (ARR) or the Return on Investment (ROI). ARR measures the average annual rate of return generated by an investment in terms of accounting profit as a percentage of the initial investment.
The ARR formula is calculated by dividing the average annual accounting profit by the initial investment cost and then multiplying the result by 100 to get the percentage:
ARR = (Average annual accounting profit ÷ Initial investment cost) × 100
Where:
Average annual accounting profit is calculated as the total expected accounting profit over the useful life of the investment divided by the number of years in that life.
Initial investment cost is the total cost of the investment, including any installation or delivery costs, and less any salvage value or residual value at the end of the investment’s useful life.
For example, suppose a company invests $100,000 in a new manufacturing plant that is expected to have a useful life of 5 years. The plant is expected to generate annual accounting profits of $20,000 per year. The average annual accounting profit can be calculated as follows:
Average annual accounting profit = Total expected accounting profit ÷ Useful life of the investment
= ($100,000 – $20,000) ÷ 5 years
= $16,000
Using this information, we can calculate the ARR as follows:
ARR = (Average annual accounting profit ÷ Initial investment cost) × 100
= ($16,000 ÷ $100,000) × 100
= 16%
This means that the investment is expected to generate an average annual accounting profit of 16% of the initial investment cost over its useful life.
ARR is a simple method that is easy to calculate and understand, making it a popular capital budgeting technique. However, it has some limitations. ARR does not consider the time value of money, so it does not provide an accurate measure of the investment’s profitability over time. It also does not consider the cash flow generated by the investment, which is an important consideration in capital budgeting.
Advantages of Accounting Rate of Return (ARR):
- Simple to Calculate: ARR is a simple and easy-to-calculate method of evaluating the profitability of an investment project. It requires only basic accounting information, which is readily available from the financial statements.
- Uses Accounting Data: ARR is based on accounting data, which is more readily available and reliable than estimates of future cash flows. This makes ARR a more reliable method for evaluating investments than methods based on estimates of future cash flows.
- Measures Profitability: ARR measures the profitability of an investment project in terms of accounting profits, which is an important consideration for many companies.
- Useful for Comparing Investment Projects: ARR is useful for comparing investment projects of similar size and duration. It enables companies to select the most profitable investment project from a range of alternatives.
Disadvantages of Accounting Rate of Return (ARR):
- Ignores the Time Value of Money: ARR does not take into account the time value of money, which means that it does not consider the present value of future cash flows. This can lead to inaccurate results, especially for long-term investment projects.
- Ignores Cash Flows: ARR ignores the timing and size of cash flows, which are important considerations in capital budgeting. It is possible for an investment project to have a high ARR but still generate negative cash flows.
- Ignores the Cost of Capital: ARR does not take into account the cost of capital, which is the minimum rate of return that an investment project must earn to compensate investors for the risk they are taking. This can lead to an overestimation of the profitability of an investment project.
- Ignores Non-Accounting Factors: ARR ignores non-accounting factors such as market conditions, technological changes, and competition. These factors can have a significant impact on the profitability of an investment project, but they are not taken into account by ARR.
- Subjective Selection of Accounting Profit: The selection of accounting profit may be subjective as it depends on the management’s accounting policies and assumptions. This may result in different ARR calculations for the same project.