Accounting rate of return is another method of calculating the profitability and feasibility of a project or investment. It attempts to compare the 'profit' of he project with a capital invested and usually express as a percentage.
the formula is as follows:
ARR = (profit/capital employed) X 100
There are some problems arising from this definition.
Definition of profit. Normally the average annual net profit earned by a project would be used. But accounting profit can be a subject to a number of different assumptions (depreciation, taxation, inflation). The most common approach is to take profit before taxation and inflation. The profit included in the equation would be the simple average of the profit that the project earns over its entire life.
Definition of capital employed. The capital employed could be either the initial capital employed or the average capital employed over its life.
Therefore, depending on the definition, the ARR may be calculated in two ways.
ARR = ( Annual average net profit before interest and taxation / Initial capital employed on the project) X 100
or,
ARR = (Annual average net profit before interest and taxation / Average annual capital employed on the project ) X 100
Example
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
This method, however, as other methods have its advantages and disadvantages. One advantage is that it is comparable with similar financial ratios used in accounting, it is relatively east to understand and draws attention to the notion of the profits.
However, the net profit can be subject to many definitions, for example it may or may not include the depreciation of the project. It is not always clear on whether the original cost of the investment should be used or whether it is more appropriate to do the average for the amount of capital invested into a project. The estimation of residual values is very difficult but it can make all the difference between one project and another. This method does also not take into account the time value for money. Irrespective of the disadvantages, however, this method may be very useful for short-term project comparison.
The use
Accounting rate of return (ARR) is the average net income an asset is expected to generate divided by the average capital cost, expressed in an annual percentage.
It is used in situations, when companies deciding on whether or not to invest in an asset based on the future net earnings expected compared to the capital cost.
If the ARR is equal to 5%, it means that the project is expected to earn 5 pence for every pound invested per year. Generally, if the ARR is equal or greater then the company's required rate of return, the project is acceptable.
For example, a company A is looking to invest in some new machinery to replace its current faulty one. The new machine will cost £420,000 which would increase annual revenue of £200,000 and annual expenses by £50,000. The machine estimated useful life is 12 years and zero salvage value.
First, we would calculate the average annual profit ( £200,000 X 12 years) which would be £2,400,000. Less annual expenses (£50,000 X 12 years = £600,000) and less depreciation of £420,000, the total profit would be approx. £1,380,000. Further, the Annual average profit would be £115,000 ( £1,380,000/12).
Then, we calculate the Average investment ($420,000 + £0.0)/2 = £210,000
Finally, we use the ARR Formula = $115,000 / £210,000 = 54,76%
This means that for every pound invested, the investment will return a profit of approx. 54.76 pence.
Another example
Company B is considering investing in the project that requires an initial investment of £100,000 for some machinery. There will be net inflows of £20,000 for the first two years, £10,000 for the year 3 and 4, and £30,000 in year 5. The machine has a salvage value of £25,000.
First we calculate the average annual profit.
Inflows in year 1 and 2 = £40,000 ( £20,000 X 2)
Inflows in year 3 and 4 = £20,000 (£10,000 X 2)
Inflow in year 5 = £30,000
Less depreciation (£100,000-£25,000) = £75,000
Total profit = £15,000
Annual average profit = £3,000 (£15,000 / 12)
Then we calculate the average investment ( £100,000 + £25,000) / 2 = £62,500
And finally, we use the ARR formula = £3,000 / £62,500 = 4.8%
Summary
The accounting return of investment is an accounting formula that reflects the percentage rate of return expected on an investment or asset compared to the initial investment cost. As per examples, it divides the average assets revenue by the company's initial investment to derive the ratio that may be expected for the lifetime of an asset or project. It does not account for cashflows, however.
This method is commonly used when comparing multiple projects and provide the expected rate of return of different projects.
This method is a capital budgeting metric that can be useful when we want to calculate an investment profitability quickly. ARR factors in any possible annual expenses including depreciation. If the investment is a fixed asset, such as property, plant and equipment we need to subtract any depreciation from the annual revenue to achieve the annual net profit.
The accounting rate of return is a simple calculation that does not require helpful math and allows for determining a projects annual percentage rate of return. This is to help managers to decide on how to proceed with the project. It comes in handy, when managers need to quickly compare the return of a project without needing to consider the time frame or payment schedule rather then just profitability of lack thereof.
Despite the advantages this formula has its limitations. It does not consider the time value of money. It is the concept that money are available at the present time is worth more then in the future because of its potential earning capacity.
The accounting rate of return does not consider the increased risks of long-term projects and the increased uncertainty associated with long-term periods. It does not take into account of the cashflow timings. There may be a lack of cashflow in the initial years and we need to be prepared for withstanding for the years period without any initial cashflows.
We must remember, that depreciation will reduce the rate of return. It is the direct cost and reduces the value of any asset or profit of a company and it will reduce return on investment of a project like any other cost.
When a company is presented with an option of multiple projects, the decision rule is that the company should accept the project with the highest accounting rate as long as the return will equal the cost of the capital employed. Therefore the method is a handy tool for making decisions.
Bibliography
CFI Team, 2023, "ARR - Accounting rate of return", Accessed from https://corporatefinanceinstitute.com/resources/accounting/arr-accounting-rate-of-return/, Accessed on 23/04/2023
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
Investopedia, 2022, " Accounting Rate of return (ARR): Definition, How to Calculate, and Example", accessed from https://www.investopedia.com/terms/a/arr.asp, Accessed on 23/04/2023
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