Accounting Rate of Return (ARR): Definition, Formula, and How to Calculate It
The Accounting Rate of Return (ARR) is a financial metric used to evaluate the profitability of an investment. It measures the expected annual accounting profit from an investment as a percentage of the initial investment cost. Businesses use ARR to compare different investment opportunities and assess whether a project meets their required return threshold.
What Is the Accounting Rate of Return (ARR)?
The Accounting Rate of Return (ARR) is a simple profitability measure that calculates the return on an investment based on accounting profits rather than cash flows. Unlike other investment evaluation methods, such as Net Present Value (NPV) or Internal Rate of Return (IRR), ARR does not consider the time value of money.
Key Features of ARR:
- Uses accounting profits instead of cash flows.
- Expressed as a percentage.
- Helps businesses decide whether to proceed with an investment.
- Does not account for time value of money.
ARR Formula
The formula for Accounting Rate of Return (ARR) is:
ARR=(Average Annual Accounting ProfitInitial Investment Cost)×100ARR = \left( \frac{\text{Average Annual Accounting Profit}}{\text{Initial Investment Cost}} \right) \times 100
Where:
- Average Annual Accounting Profit = Total profit from the investment divided by the number of years.
- Initial Investment Cost = Total cost of acquiring the investment.
How to Calculate ARR: Step-by-Step
Example Calculation
Scenario:
A company is considering investing $50,000 in a new machine. The machine is expected to generate $12,000 in annual accounting profit over 5 years.
Step 1: Calculate the Average Annual Accounting Profit
Since the machine generates $12,000 per year for 5 years, the average annual profit remains $12,000.
Step 2: Apply the ARR Formula
ARR=(12,00050,000)×100ARR = \left( \frac{12,000}{50,000} \right) \times 100 ARR=24%ARR = 24\%
The Accounting Rate of Return (ARR) is 24%, meaning the investment is expected to generate an annual return of 24% based on accounting profits.
Advantages of Using ARR
✅ Simple to Calculate – Requires basic financial information and no complex calculations.
✅ Uses Readily Available Data – Based on accounting profits, which are easily accessible in financial statements.
✅ Good for Comparing Investments – Helps businesses rank investment opportunities based on expected profitability.
Disadvantages of ARR
❌ Ignores the Time Value of Money – Unlike NPV or IRR, ARR does not account for the decreasing value of future profits.
❌ Based on Accounting Profits, Not Cash Flows – It does not consider actual cash flows, which may be more relevant for decision-making.
❌ Ignores Risk and Uncertainty – ARR assumes that profits will remain constant over time, which may not always be the case.
ARR vs. Other Investment Appraisal Methods
| Method | Uses Accounting Profits? | Considers Time Value of Money? | Best For |
|---|---|---|---|
| ARR | ✅ Yes | ❌ No | Quick profitability estimates |
| Net Present Value (NPV) | ❌ No (uses cash flows) | ✅ Yes | Long-term investment analysis |
| Internal Rate of Return (IRR) | ❌ No (uses cash flows) | ✅ Yes | Comparing investment opportunities |
| Payback Period | ❌ No (uses cash flows) | ❌ No | Measuring investment risk |
When to Use ARR
ARR is best suited for:
- Small businesses and startups evaluating quick investment decisions.
- Comparing multiple investment options based on profitability.
- Assessing long-term projects where accounting profits are a key consideration.
Final Thoughts
The Accounting Rate of Return (ARR) is a simple yet useful financial metric for evaluating investment profitability. While it provides a quick percentage-based return estimate, it has limitations such as ignoring the time value of money and cash flow variations. Businesses should use ARR alongside other investment evaluation methods, such as NPV and IRR, for more accurate financial decision-making.
