Accounting Rate Of Return (ARR) - Meanings, Formulas, Examples, Advantages & Disadvantages

Accounting Rate of Return (ARR)

ARR is the expected percentage of return on the investment. ARR is also known as “Average Rate of return”. ARR represent as a financial ratio which used in capital budgeting. The ratio does not take into account the concept of time value and money. ARR calculates the return, which generate from net income upon total investment. The key advantage of ARR is that it is easy to calculate and understand. ARR divides the average revenue from an asset by the company's initial investment to derive the ratio or return that can be expected over the lifetime of the asset or related project.

Under this method, the asset’s expected accounting rate of return (ARR) is computed by dividing the expected incremental net operating income by the initial investment and then compared to the management’s desired rate of return to accept or reject a proposal. If the asset’s expected accounting rate of return is greater than or equal to the management’s desired rate of return, the proposal is accepted. Otherwise, it is rejected. The accounting rate of return is computed using the following formula:

Formula

• ARR = PBIT / Total Capital Employed
• ARR = Total Cash Flow – Depreciation / Initial Investment
• ARR = Incremental Accounting Income / Initial Investment
• ARR = Net Cost Saving / Initial Investment
• ARR = Average Annual Profit / Average Investment
• Average Annual Profit = Total profit over Investment Period / Number of Years
• Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

Examples

ABC Company is looking to invest in some new machinery to replace its current malfunctioning one. The new machine, which costs ₹420,000, would increase annual revenue by ₹200,000 and annual expenses by ₹50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.

Step 1: Calculate Average Annual Profit

Inflows
₹200000*12	₹2400000
Less: Annual Expenses
₹50000*12	-₹600000
Less: Depreciation	-₹420000
Total Profit	₹1380000
Average Annual Profit
₹1380000/12	₹115000

Step 2: Calculate Average Investment

Average Investment      

(₹420,000 + ₹0)/2 = ₹210,000

 Step 3: Use ARR Formula

ARR = ₹115,000/₹210,000 = 54.76%

Note: Therefore, this means that for every dollar invested, the investment will return a profit of about 54.76 cents.

Advantages

• Help to Compare
• Easier  to Calculate
• Clear view of Profitability
• Create the perception of net earning
• Satisfies the interest of owner
• Measuring the current performance
• Easy to calculate return rate

Disadvantages

• The ignorance of the time factor
• Ignorance of the external factor
• Create decision making problems
• Only considered accounting's profit
• Unhelpful at sometimes
• Life Period Investment

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