How to Calculate Accounting Rate of Return in Excel

The accounting rate of return (ARR) is a financial metric used to evaluate the profitability of an investment by accounting professionals. Unlike the internal rate of return (IRR), ARR uses the initial investment cost rather than the net present value (NPV) of future cash flows. This guide explains how to calculate ARR in Excel with step-by-step instructions and an interactive calculator.

What is Accounting Rate of Return?

The accounting rate of return is calculated by dividing the annual net income by the average investment cost. It provides a simple measure of how much profit is generated per dollar invested each year. Accounting professionals often use ARR to compare different investment opportunities or to assess the performance of existing investments.

Key characteristics of ARR include:

Uses the initial investment cost rather than the net present value of future cash flows
Provides a straightforward annualized return measure
Does not account for the time value of money
Can be used for both capital investments and operating activities

ARR is particularly useful for comparing investments of different sizes and durations, as it standardizes the return measure across all investments.

Accounting Rate of Return Formula

The formula for accounting rate of return is:

Accounting Rate of Return = (Annual Net Income / Average Investment Cost) × 100

Where:

Annual Net Income is the total profit generated by the investment during the year
Average Investment Cost is the average of the initial investment and the final investment value

This formula provides a percentage that represents the annual return on the average investment.

How to Calculate in Excel

Calculating accounting rate of return in Excel involves several steps. Here's a step-by-step guide:

Enter the initial investment in cell A2
Enter the final investment value in cell A3
Enter the annual net income in cell A4
Calculate the average investment cost in cell A5 with the formula: =AVERAGE(A2:A3)
Calculate the accounting rate of return in cell A6 with the formula: =((A4/A5)*100)

This will give you the accounting rate of return as a percentage.

For more complex scenarios with multiple years, you can create a table with columns for each year's net income and investment values, then calculate the average investment cost and annual net income over the period.

Example Calculation

Let's calculate the accounting rate of return for an investment with the following details:

Description	Value
Initial Investment	$100,000
Final Investment Value	$120,000
Annual Net Income	$15,000

Using the formula:

Average Investment Cost = ($100,000 + $120,000) / 2 = $110,000

Accounting Rate of Return = ($15,000 / $110,000) × 100 = 13.64%

The accounting rate of return for this investment is 13.64%.

Interpretation of Results

Interpreting the accounting rate of return involves understanding what the percentage means in the context of your investment:

A higher ARR indicates a more profitable investment relative to the average investment cost
The ARR does not account for the time value of money, so it may not reflect the true economic value of the investment
ARR is particularly useful for comparing investments of different sizes and durations
For accounting purposes, ARR is often used to assess the performance of investments against budgeted returns

While ARR provides a simple measure of return, it should be used in conjunction with other financial metrics for a complete investment analysis.

FAQ

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

The accounting rate of return uses the initial investment cost to calculate the return, while the internal rate of return uses the net present value of future cash flows. ARR is simpler and easier to calculate, while IRR accounts for the time value of money.

Can accounting rate of return be negative?

Yes, the accounting rate of return can be negative if the annual net income is negative, indicating a loss rather than a profit.

Is accounting rate of return suitable for all types of investments?

ARR is most suitable for comparing investments of different sizes and durations, as it standardizes the return measure across all investments. It may not be appropriate for investments with highly variable cash flows.

How does accounting rate of return differ from return on investment (ROI)?

Both ARR and ROI measure the profitability of an investment, but ROI typically uses the initial investment cost, while ARR can incorporate the final investment value in the calculation.