Calculating Accounting Rate of Return

The accounting rate of return (ARR) is a financial metric used to evaluate the profitability of an investment or project. Unlike the internal rate of return (IRR), which considers the time value of money, ARR provides a straightforward measure of profitability without discounting future cash flows. This guide explains how to calculate ARR, its applications, and how it compares to other financial ratios.

What is Accounting Rate of Return?

The accounting rate of return is a simple profitability measure that compares the net income generated by an investment to the total investment cost. It is calculated by dividing the net income by the total investment cost and then multiplying by 100 to express it as a percentage.

ARR is particularly useful for comparing the profitability of different investments or projects, especially when the investments have different lifespans or cash flow patterns. It provides a quick snapshot of how much profit is generated per dollar invested.

Key Points

ARR does not account for the time value of money, unlike IRR.
It is a straightforward measure of profitability without discounting.
Useful for comparing investments with different lifespans.

How to Calculate Accounting Rate of Return

Calculating the accounting rate of return involves a few straightforward steps. You will need the net income generated by the investment and the total investment cost. The formula for ARR is:

Accounting Rate of Return Formula

ARR = (Net Income / Total Investment Cost) × 100

To calculate ARR, follow these steps:

Determine the net income generated by the investment over the relevant period.
Identify the total investment cost, which includes all initial outlays.
Divide the net income by the total investment cost.
Multiply the result by 100 to convert it to a percentage.

The resulting percentage represents the accounting rate of return, indicating how much profit is generated per dollar invested.

Accounting Rate of Return Formula

The formula for calculating the accounting rate of return is simple and straightforward. It is based on the net income generated by the investment and the total investment cost. The formula is:

ARR Formula

ARR = (Net Income / Total Investment Cost) × 100

Where:

Net Income is the total profit generated by the investment after accounting for all expenses.
Total Investment Cost is the sum of all initial outlays required to make the investment.

The result is expressed as a percentage, providing a clear measure of profitability.

Example Calculation

To illustrate how to calculate the accounting rate of return, let's consider an example. Suppose a company invests $100,000 in a new project and generates a net income of $20,000 over the same period.

Using the ARR formula:

Example Calculation

ARR = ($20,000 / $100,000) × 100 = 20%

In this example, the accounting rate of return is 20%, indicating that the investment generated a 20% return on the total investment cost.

This example demonstrates how ARR provides a simple and clear measure of profitability, making it easy to compare different investments.

Comparison with Other Ratios

The accounting rate of return is one of several financial metrics used to evaluate investment profitability. It is often compared to other ratios such as the internal rate of return (IRR) and the payback period.

Metric	Description	Key Difference
Accounting Rate of Return (ARR)	Measures profitability without discounting future cash flows.	Simple and straightforward, but does not account for time value of money.
Internal Rate of Return (IRR)	Considers the time value of money by discounting future cash flows.	More complex and accurate, but requires more data.
Payback Period	Measures the time it takes to recover the initial investment.	Focuses on recovery time rather than profitability.

While ARR provides a simple measure of profitability, it does not account for the time value of money. The IRR, on the other hand, considers the time value of money by discounting future cash flows, providing a more accurate measure of investment profitability. The payback period focuses on the time it takes to recover the initial investment, rather than profitability.

FAQ

What is the difference between accounting rate of return and internal rate of return?

The accounting rate of return (ARR) is a simple measure of profitability that does not account for the time value of money. The internal rate of return (IRR), on the other hand, considers the time value of money by discounting future cash flows, providing a more accurate measure of investment profitability.

How is accounting rate of return different from payback period?

The accounting rate of return measures profitability without discounting future cash flows, while the payback period measures the time it takes to recover the initial investment. ARR provides a simple measure of profitability, while the payback period focuses on recovery time.

When should I use accounting rate of return instead of internal rate of return?

Use accounting rate of return when you need a simple and straightforward measure of profitability without considering the time value of money. Use internal rate of return when you need a more accurate measure of investment profitability that accounts for the time value of money.