What Is Accounting Rate of Return (ARR)?
Accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment's cost. The ARR formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one may expect over the lifetime of the asset, or related project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.
Rate of Return
The Formula for ARR
How to Calculate Accounting Rate of Return
- Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
- If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any depreciation expense from the annual revenue to achieve the annual net profit.
- Divide the annual net profit by the initial cost of the asset, or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.
What Does ARR Tell You?
Accounting rate of return is a capital budgeting metric that's useful if you want to calculate an investment's profitability quickly. Businesses use ARR primarily to compare multiple projects to determine the expected rate of return of each project, or to help decide on an investment or an acquisition. ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset. This lets the company earn a profit from the asset right away, even in its first year of service.
- The accounting rate of return (ARR) formula is helpful in determining the annual percentage rate of return of a project.
- You may use ARR when considering multiple projects, as it provides the expected rate of return from each project.
- However, ARR does not differentiate between investments that yield different cash flows over the lifetime of the project.
How to Use ARR
As an example, a business is considering a project that has an initial investment of $250,000 and forecasts that it would generate revenue for the next five years. Here's how the company could calculate the ARR:
- Initial investment: $250,000
- Expected revenue per year: $70,000
- Time frame: 5 years
- ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
- ARR = 0.28 or 28% (0.28 * 100)
The Difference Between ARR and RRR
The ARR is the annual percentage return from an investment based on its initial outlay of cash. Another accounting tool, the required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.
The RRR can vary between investors as they each have a diffferent tolerance for risk. For example, a risk-averse investor likely would require a higher rate of return to compensate for any risk from the investment. It's important to utilize multiple financial metrics including ARR and RRR, to determine if an investment would be worthwhile based on your level of risk tolerance.
Limitations of Using ARR
The accounting rate of return is helpful in determining a project's annual percentage rate of return. However, the calculation has its limitations.
ARR doesn't consider the time value of money (TVM). The time value of money is the concept that money available at the present time is worth more than an identical sum in the future because of its potential earning capacity. In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.
The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.
Also, ARR does not take into account the impact of cash flow timing. Let's say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn't yield any revenue until the fourth and fifth year. In this case, the ARR calculation would not factor in the lack of cash flow in the first three years, and the investor would need to be able to withstand the first three years without any positive cash flow from the project.