Average accounting return, also called accounting rate of return or ARR, is an accounting method used for the purposes of comparison with other capital budgeting calculations, such as NPV, PB period and IRR.

ARR provides a quick estimate of a project's worth over its useful life. ARR is calculated by finding a capital investment's average operating profits before interest and taxes but after depreciation and amortization (also known as "EBIT") and dividing that number by the book value of the average amount invested. It can be expressed as the following:

ARR = Average Profit / Average Investment

The result is expressed as a percentage. In other words, ARR compares the amount invested to the profits earned over the course of a project's life. The higher the ARR, the better.

The major drawbacks of ARR are as follows:

1. It uses operating profit rather than cash flows. Some capital investments have high upkeep and maintenance costs, which bring down profit levels. 2. Unlike NPV and IRR, it does not account for the time value of money. By ignoring the time value of money, the capital investment under consideration will appear to have a higher level of return than what will occur in reality. The capital investment may appear to be more lucrative than the alternatives, such as investing in the financial markets, when it is actually less lucrative.

Here is a simple example of an ARR calculation: A project requiring an average investment of $1,000,000 and generating an average annual profit of $150,000 would have an ARR of 15%.

While ARR is easy to calculate and can be used to gauge the results of other capital budgeting calculations, it is not the most accurate metric.

Internal Rate Of Return

Related Articles
  1. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  2. Small Business

    Calculating IRR with Excel

    Find out how to calculate the internal rate of return on investments using Microsoft Excel, as illustrated in different investment scenarios.
  3. Investing

    Internal rate of return: An inside look

    The internal rate of return can be used to measure an compare capital projects, stock buyback programs, and investments to determine which will yield the most favorable return.
  4. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  5. Trading

    Top 5 Budgeting Questions Answered

    You don't need a degree to understand your money, begin saving and pay down debt.
  6. Investing

    Methods used in valuing private companies

    There are a few methods for calculating the valuation of a private company. By using financial information from peer groups, we can estimate the valuation of a target firm.
  7. Personal Finance

    Budgeting Tips for Beginners

    Consider these basic budgeting tips to save, invest and spend your money efficiently.
Trading Center