Accounting Rate of Return (ARR), also popularly known as the average rate of return measures the expected profitability from any capital investment. The ARR is a formula used to make capital budgeting decisions.
It is used in situations where companies are deciding on whether or not to invest in an asset (a project, an acquisition, etc.) based on the future net earnings expected compared to the capital cost.
HOW TO USE ARR ?
The formula for ARR is =
Average Annual Profit / Average Investment
- Average Annual Profit = Total profit over Investment Period / Number of Years
- Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
For example: If a company projects that it will earn an average annual profit of $70,000 on an initial investment of $1,000,000, then the project has an accounting rate of return of 7%.
Accounting Rate of Return formula is used in capital budgeting projects and can be used to evaluate when there are multiple projects, and only one or a few can be selected.
If the ARR is equal to or greater than the company’s required rate of return , then the project can be accepted .
On the other hand, if the ARR is lower than the company’s required rate of return then the project must be rejected.
This means that higher the ARR , the more profitable the company will become.
LIMITATIONS OF USING ARR
- It ignores the time value of money. It assumes accounting income in future years has the same value as accounting income in the current year.
- ARR does not take into account the impact of cash flow timing.
- The measure is not adequate for comparing one project to another, since there are many other factors than the rate of return that should be considered, which cannot be expressed in quantitative terms.
- It does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.
Thus, in simple words Accounting/Average Rate of Return refers to the rate of return which is expected to be earned on the investment with respect to investments’ initial cost. It is not by any means a perfect method for evaluating a capital project, and so should be used only in concert with a number of other evaluation tools like IRR (internal rate of return).