Accounting Rate of Return

What is the Accounting Rate of Return (ARR)?

The Accounting Rate of Return is a metric used to measure the profitability of an investment project or asset by comparing the expected net profit to the investment cost. ARR is commonly used in capital budgeting and investment decision-making to assess the economic viability and return on investment of a project. This metric focuses on the accounting yield of a project or asset, which represents the relationship between the expected net profit and the investment cost.

Formula for Calculating ARR

The formula for calculating ARR may vary depending on specific circumstances and requirements. Here are two common formulas:

Average Annual Net Profit Method

ARR = (Expected Net Profit / Investment Cost) × 100%

Here, the expected net profit refers to the anticipated net profit that the project or asset will generate over its expected useful life, and the investment cost refers to the cost required to invest in the project or purchase the asset.

Average Annual Profit Method

ARR = (Average Annual Net Profit / Investment Cost) × 100%

Here, the average annual net profit is the average annual profit generated by the project or asset, and the investment cost refers to the cost required to invest in the project or purchase the asset.

Characteristics of ARR

1. Based on Accounting Data: ARR is derived from accounting statements and data, focusing on the accounting yield of a project or asset, i.e., the relationship between expected net profit and investment cost.
2. Simple Calculation: Compared to other complex financial metrics and evaluation methods, ARR calculation is relatively simple and straightforward. It often uses simple formulas that require basic accounting data.
3. Internal Evaluation Tool: ARR is often used in internal decision-making and capital budgeting analyses to help companies evaluate the economic viability and return on investment of projects, and to aid in investment decisions and resource allocation.
4. Static Metric: ARR is a static metric based on the ratio of expected net profit to investment cost, without considering the time value of cash flows and changes in investment returns.
5. Dependent on Accounting Assumptions: ARR calculations rely on accounting assumptions and forecast data. Its accuracy and reliability are influenced by the accuracy of predicted net profit and investment cost.
6. Ignores Non-Financial Factors: ARR mainly focuses on accounting data and may overlook some non-financial factors such as market trends, risks, and competition. Therefore, a comprehensive decision should also consider other factors.
7. Limited Applicability: ARR is applicable to projects or assets with stable income and predictable net profits. It may not be suitable for high-risk or highly uncertain projects.

Advantages and Disadvantages of ARR

As a metric for evaluating the profitability of investment projects or assets, ARR has the following advantages and disadvantages:

Advantages

1. Simple and Understandable: ARR calculation methods are relatively straightforward, using formulas based on accounting data that are easy to understand and apply.
2. Uses Accounting Data: ARR is calculated based on accounting statements and data, which can be directly obtained from a company's financial statements.
3. Internal Decision-Making Tool: ARR is often used for internal decision-making and capital budgeting analyses, helping companies to evaluate the economic viability and return on investment of projects, supporting the decision-making process.
4. Relatively Stable: Since accounting data reflect a company's operating and financial conditions, ARR can provide a relatively stable evaluation metric, reflecting long-term profitability.

Disadvantages

1. Ignores Time Value: ARR overlooks the time value of cash flows and does not consider the differences in investment returns and costs over time, potentially leading to an inaccurate estimate of the true economic benefit of an investment project.
2. Dependent on Accounting Assumptions: ARR relies on the accuracy of predicted net profit and investment cost, which depends on the accuracy of the accounting assumptions and forecast data used.
3. Ignores Non-Financial Factors: ARR mainly relies on accounting data and may overlook non-financial factors such as market trends, risks, and competition. For comprehensive decision-making, this might not be sufficient.
4. Static Metric: ARR is a static metric that only focuses on the ratio of expected net profit to investment cost, failing to capture changes and dynamics in investment returns.
5. Restricted by Accounting Standards: ARR is restricted by specific accounting standards and practices, which may result in different ARR outcomes under various accounting treatments.

Is ARR the Same as Return on Investment (ROI)?

No, ARR is not the same as ROI; they are different metrics used to measure investment profitability and return.

1. ARR is an accounting-based metric that typically measures the profitability of an investment project or asset using the ratio of expected net profit to investment cost. It is a static metric that focuses on accounting data such as net profit and investment cost.
2. ROI is a broader concept that encompasses different metrics used to evaluate the return and profitability of an investment. ROI usually considers the ratio between investment return and cost, but it can also include other factors like cash flow and time value.

Although both ARR and ROI are used to assess investment profitability, their calculation methods and focuses differ. ARR emphasizes accounting data, whereas ROI is more comprehensive and can include multiple metrics and factors.

Does ARR Consider the Time Value of Money?

Generally, ARR does not consider the time value of money. ARR calculation methods mainly rely on accounting data, particularly the ratio of expected net profit to investment cost.

Because ARR primarily focuses on accounting data, it does not explicitly account for the time value of future cash flows, i.e., the discount or compound growth of expected net profits over future periods. This may result in ARR failing to accurately reflect the true economic benefit of an investment project or asset.

Therefore, in scenarios considering the time value of money, it is more appropriate to use other evaluation metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR), which take the time value of cash flows into account. These metrics discount future cash flows to their present value, providing a more comprehensive assessment of an investment project's return and profitability.

Example of ARR

Suppose Company A is considering investing in new production equipment with a purchase cost of $100,000 and an expected useful life of 5 years, with no residual value. The projected annual net profit is $20,000.

We can now use ARR to evaluate the profitability of this investment project. The steps to calculate ARR are as follows:

1. Calculate Expected Net Profit: Annual Expected Net Profit = $20,000
2. Calculate Investment Cost: Investment Cost = $100,000
3. Calculate ARR: ARR = (Expected Net Profit / Investment Cost) × 100% = ($20,000 / $100,000) × 100% = 20%

Based on this calculation, Company A's ARR is 20%. This means that the average annual return rate of the investment project is 20%. If the company's required return rate is 15%, this investment project’s ARR exceeds the required return rate and may be considered an attractive investment option.