Accounting rate of return (ARR)

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.

Example of the accounting rate of return

Let’s say a company invests R50,000 in a new project. Over the next five years, the project generates the following annual accounting profits:

• Year 1: R10,000
• Year 2: R12,000
• Year 3: R14,000
• Year 4: R16,000
• Year 5: R18,000

Calculate the average accounting profit:

Average accounting profit = (R10,000 + R12,000 + R14,000 + R16,000 + R18,000) / 5 = R14,000

Use the formula to calculate ARR:

ARR = (R14,000 / R50,000) 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 R50,000.