Last updated by
June 10, 2022
The accounting rate of return (ARR) calculates the return on a capital investment based on the net income generated from that capital investment.
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.
Table of contents
The formula is:
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.
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.
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.