Accounting rate of return: All you need to know

Definition

The accounting rate of return (ARR) is a financial metric used to evaluate the profitability of an investment project or asset by comparing the average accounting profit generated by the investment to the initial investment cost.

What is the accounting rate of return?

ARR is often expressed as a percentage and provides insight into the average annual return generated by the investment relative to its initial cost.

To calculate the accounting rate of return, the following formula is typically used:

ARR = (Average accounting profit / Initial Investment) x 100

ARR is relatively simple to calculate and understand compared to other investment appraisal methods, making it a popular metric for small businesses or projects where complex financial analysis may not be feasible.

Keep in mind that ARR does not explicitly consider the time value of money, as it does not discount future cash flows back to their present value. This can be a limitation, especially when comparing investment projects with different cash flow timing.

While ARR may not be suitable for comparing investment projects with different durations or cash flow profiles, it can be useful for comparing similar projects or investment alternatives within an organisation.

Accounting rate of return vs. required rate of return

The accounting rate of return (ARR) compares a project’s average accounting profit to its initial investment. It measures profitability based on accounting metrics but does not account for the time value of money or risk. In contrast, the required rate of return (RRR) is the minimum return an investor expects to earn from an investment to compensate for its risk. It considers factors like opportunity cost, inflation, and the project’s risk profile. RRR guides investment decisions by making sure projects meet or exceed the investor’s expectations for profitability relative to the associated risk.

What’s the difference between accounting rate of return and internal rate of return?

The accounting rate of return (ARR) and internal rate of return (IRR) are both metrics used in financial analysis but differ in their approach and insights. ARR calculates a project’s profitability based on accounting measures, specifically comparing average accounting profit to the initial investment. In contrast, IRR determines the discount rate at which the net present value (NPV) of cash flows from a project equals zero. It incorporates the time value of money, providing a more comprehensive assessment of a project’s potential return relative to its risk.

Example of the accounting rate of return

Let’s say a company invests $50,000 in a new project. Over the next five years, the project generates the following annual accounting profits:

Year 1: $10,000
Year 2: $12,000
Year 3: $14,000
Year 4: $16,000
Year 5: $18,000

Calculate the average accounting profit:

Average accounting profit = ($10,000 + $12,000 + $14,000 + $16,000 + $18,000) / 5 = $14,000

Use the formula to calculate ARR:

ARR = ($14,000 / $50,000) x 100 = 28%

So, the accounting rate of return (ARR) for this project is 28%. This means that, on average, the project generates a return of 28% per year relative to its initial investment of $50,000.