Accounting Rate of Return Method

What is the accounting rate of return?

The accounting rate of return (ARR) refers to the measure of the expected profitability out of any capital investment. It is also known as the Average Rate of Return and indicates the profitability with the help of simple estimates. ARR is one of the oldest evaluations techniques. The accounting rate of return method divides the net income from an investment by the total amount invested, and thus evaluates the profitability of capital projects.

The accounting rate of return formula is a very important one for the investors when they want to evaluate the viability of any capital project. The accounting rate of return calculation is widely used while comparing and selecting projects for investment. Businesses use this method primarily to compare multiple projects and determine the expected rate of return for each one of them. It allows investors to assess the risk involved in any potential investment. Please note the accounting rate of return method works on estimates and does not consider inflation, taxes and interest accrued.

What are the accounting rate of return advantages and disadvantages?

When we speak of the accounting rate of return advantages and disadvantages, there are many. Here, we will list some of the most important ones –

• The accounting rate of return method is a fairly simple one. It allows an investor to know the possible return from a project in a quick and easy manner.
• It allows an investor to understand the payback pattern of a project after considering its possible economic life
• With the help of accounting rate of return, the investor can assess the risk involved in any potential investment. This helps him to decide if the proposed investment would yield sufficient earnings so as to cover the risk involved.
• The accounting rate of return calculation helps the investor to evaluate the current performance of the project in question
• It allows the investor to compare the relative profitability of different projects of a similar nature.

• The accounting rate of return is based on accounting profits only. It does not consider inflation, taxes and interest accrued. This makes the accounting rate of return method insufficient for long-term capital investments.
• The accounting rate of return formula can not be used when the investment is made in parts or at different time durations. This is because this method ignores the ‘time value’ of money. The ‘time value’ often comes out as an important factor while deciding the viability of an investment.
• The accounting rate of return (ARR) ignores important external factors. Therefore, we get different results when we analyse the same project with the help of the return on investment method. This is the reason why the accounting rate of return method, at times, is not suitable for huge projects.
• The accounting rate of return (ARR) is based on profits and ignores the important aspect of cash flow from the investment. Hence, the accounting rate of return calculation is prone to be affected by bad debts, depreciation and other such non-cash items. For the same reason, many expenses and incomes relevant to the investment proposal (such as benefits and opportunity costs) may get omitted while applying the accounting rate of return method.
  • The ARR method of accounting income and ignores the cash flow information. This makes it unsuitable for projects with high maintenance costs as the viability of such projects depends heavily on timely cash inflows.
  • ARR can be calculated in many ways. Therefore, consistency is an issue with the accounting rate of return calculation.

How to calculate the Accounting rate of return?

The accounting rate of return formula is –

ARR=Average accounting profit/average investment

Average accounting profit- It is the arithmetic mean of the profit to be earned expected profit during the lifetime of the project

Average investment- When we add the starting and ending book value of a project and divide the sum by two, we get the average investment. However, in some cases, instead of the average value, the initial value of the investment is also considered.

After the accounting rate of return calculation is done, the time comes for the decision making process. If the result thus obtained is more than or equal to the desired accounting rate of return (ARR), then the project is considered profitable for investment. Also, while comparing the profitability of two or more projects, the one with a better ARR is accepted.

The following example will make the accounting rate of return method clearer to you-

Let us suppose the average annual profit for a project during its lifetime is Rs 30,000. Also, the average value of an investment in a particular year is Rs 1,00,000. In this case, the accounting rate of return will be calculated as-

ARR= 30000/100000

= 30%

Let us take another example.

Let us suppose an investor needs to decide on two investment proposals.

Project A has an estimated average profit (per annum) of Rs 40,000. Also, the average value of investment of this project for a particular year is Rs 200000. Therefore, the accounting rate of return for project A will be = (40000/200000) * 100%

= 20%

Project B has an estimated average profit (per annum) of Rs 30,000. Also, the average value of investment of this project for a particular year is Rs 100000. Therefore, the accounting rate of return for project B will be = (30000/100000) * 100%

= 30%

Now, while looking at the comparative accounting rate of return, the investor finds out that the second proposal (project B) has better investment viability as it has a better ARR. Hence, he is more likely to opt for project B.

In general, the accounting rate of return calculation is carried out both before deciding on the investment and also on a year-to-year basis. Applying the accounting rate of return method on a year-to-year basis is necessary as the ARR calculation does not take into account multi-period and external variables.

What are the points to consider while calculating the accounting rate of return?

You should keep in mind the following points while calculating the accounting rate of return-

• While calculating the annual net profit from any investment, you must include the revenue minus any annual cost/expenses of implementing the project
• If the investment is on a fixed asset such as a plant, equipment or property, you should subtract the depreciation from the annual revenue while calculating the annual net profit.

FAQs on Accounting Rate of Return Method

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