Accounting Rate of Return
The accounting rate of return (ARR) also known as the average rate of return is a capital budgeting method used for determining whether it would be beneficial to proceed with a specific project/ investment. In other words, it helps you in calculating the return you would make on your investment. The important thing to note here is that ARR unlike other capital budgeting methods uses profits instead of cash flows. The formula for the accounting rate of return is as follows:
ARR = (Average annual accounting profit ÷ Investment) x 100
It is mainly used by businesses to compare multiple projects by calculating the rate of return expected from each project or to help decide whether to go through an acquisition or investment.
Example of How ARR Works?
ABC Corporation is considering taking up a project that requires an initial investment of $150,000 and forecasts that it will start generating revenue in the next four years. The average annual profit the project is expected to yield is $18,000.
The accounting rate of return of the said project would be:
ARR = ($18,000/ $150,000) x 100 = 12%
Limitations of ARR
The accounting rate of return is mainly used for computing the annual rate of return of a project. However, the calculation has its flaws:
- The accounting rate of return does not consider or take into account the concept of the time value of money. As per the said concept, the money available or invested at the present time is worth more than an identical sum to be received in the future because of its earning potential.
- The calculation does not take into account the increased risk of projects that last longer than a year and the increased uncertainty associated with longer time periods
- It also does not considers the impact of the cash flow timing.