Account Rate of Return (ARR)

Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR) is a straightforward capital budgeting method used to measure the profitability of an investment by calculating the average annual accounting profit as a percentage of the initial investment. Also known as the Average Rate of Return (ARR) or Return on Investment (ROI), ARR provides a quick snapshot of the expected profitability without considering the time value of money.

ARR Formula

$\mathrm{ARR}=(\frac{\mathrm{Average\; annual\; accounting\; profit}}{\mathrm{Initial\; investment\; cost}})\times 100$

Where:

• Average annual accounting profit: Total expected accounting profit over the investment's useful life divided by the number of years.
• Initial investment cost: Total cost of the investment, including installation or delivery costs, minus any salvage value at the end of the investment’s useful life.

Example Calculation

Suppose a company invests $100,000 in a new manufacturing plant expected to have a useful life of 5 years. The plant generates annual accounting profits of $20,000 per year.

• Average annual accounting profit:

$=\frac{5\times \mathrm{20,000}}{5}=\mathrm{20,000}$

• ARR Calculation:

$\mathrm{ARR}=(\frac{\mathrm{20,000}}{\mathrm{100,000}})\times 100=20\%$

This means the investment is expected to generate an average annual accounting profit of 20% of the initial investment cost over its useful life.

Advantages of ARR

• Simple to Calculate:
  • Ease of Use: ARR is straightforward and easy to calculate using basic accounting information from financial statements. This simplicity makes it accessible to managers without extensive financial expertise.
• Uses Accounting Data:
  • Reliability: ARR relies on historical accounting data, which is typically more accurate and reliable than uncertain future cash flow estimates. This provides a level of assurance in the profitability analysis.
• Measures Profitability:
  • Focus on Accounting Profits: ARR measures profitability in terms of accounting profits, which is a key consideration for many companies when evaluating investment performance.
• Useful for Comparing Investment Projects:
  • Comparative Analysis: ARR is useful for comparing the profitability of similar-sized investment projects over similar time periods, aiding in the selection of the most profitable option.

Disadvantages of ARR

• Ignores the Time Value of Money:
  • Lack of Discounting: ARR does not consider the time value of money, which can lead to inaccurate results, particularly for long-term investments. Future profits are not discounted to their present value, potentially overstating profitability.
• Ignores Cash Flows:
  • Cash Flow Neglect: ARR focuses on accounting profits and ignores the timing and size of cash flows. An investment might show a high ARR but could still have negative cash flows, leading to liquidity issues.
• Ignores the Cost of Capital:
  • Risk and Return: ARR does not account for the cost of capital, which is the minimum return required by investors. This omission can lead to overestimating the project's profitability and making suboptimal investment decisions.
• Ignores Non-Accounting Factors:
  • External Factors: ARR does not consider market conditions, technological changes, or competitive dynamics, which can significantly affect the actual profitability of an investment.
• Subjective Selection of Accounting Profit:
  • Accounting Policies Impact: The calculation of accounting profit can be subjective and influenced by management's accounting policies and assumptions. This subjectivity can lead to different ARR values for the same project under different accounting practices.

Additional Considerations

• Comparative Tools:
  • While ARR provides a quick profitability measure, it is often used alongside other capital budgeting tools like Net Present Value (NPV) and Internal Rate of Return (IRR) to provide a comprehensive investment evaluation.
• Risk Assessment:
  • It's essential to conduct a risk assessment alongside ARR calculations to account for uncertainties and ensure that all potential risks are considered.

Conclusion

ARR offers a simple and easily understandable method for evaluating the profitability of investment projects using readily available accounting data. However, its limitations, particularly the neglect of the time value of money, cash flows, and cost of capital, mean it should not be used in isolation. Combining ARR with other more sophisticated methods provides a more balanced and accurate assessment of investment opportunities.