Understanding Accounting Rate of Return (ARR)

Businesses can use accounting rate of return when weighing whether a major use of capital, such as new equipment or an acquisition, produces enough accounting profit to merit consideration. The calculation relates the profit recorded from an investment to the capital committed to it. A company can then compare that percentage with its own standard for approving a project.

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How to Calculate Accounting Rate of Return

One way to evaluate a proposed purchase is to calculate ARR from the accounting earnings attributed to the project and the capital tied to it. For example, suppose equipment represents an average investment of $100,000 which adds $20,000 per year to profits. Those figures produce an ARR of 20%:

Average annual profit increase $20,000 / Average investment cost $100,000 = 0.20
The ARR on this investment is 0.20 x 100 or 20%.

Begin with the earnings the business expects the asset to contribute during its operating years. The accounting profit used for arriving at the ARR also includes depreciation.

Next, estimate the asset value that will serve as the denominator. One approach averages what the asset is worth on the company’s books when purchased and what remains at the end of the holding period.

Consider equipment bought for $100,000. Over 10 years, assume it contributes $150,000 in profit before $90,000 of recognized depreciation occurs and retains $10,000 of value when the business no longer needs it.

First, calculate depreciation and average annual profit:

Additional profits: $150,000
Minus depreciation (purchase cost minus salvage value): $90,000
Total profits after depreciation: $60,000
Average annual profit over 10 years: $6,000
Second, calculate the average investment:
Average investment ($100,000 first year book value plus $10,000 last year book value) / 2 = $55,000
Now apply the accounting rate of return formula:
$6,000 / $55,000 = 0.109

Expressed as a percentage, the result is about 10.9%. The business can use that number as one input when deciding whether the purchase clears its investment standard.

Accounting Rate of Return Pros and Cons

Suppose company policy calls for a 15% ARR before it commits money to a project. At 10.9%, the equipment falls 4.1 percentage points short, so it would not qualify under that policy.

ARR can provide a quick way to assess projects using figures already found in accounting forecasts. Its simplicity is also a limitation. The calculation does not adjust earnings according to when they occur. This means an amount recorded several years from now receives the same treatment as an equal amount recorded much sooner. Project length can therefore affect how useful the percentage is for comparing alternatives.

ARR is based on accounting earnings rather than the actual timing of money entering and leaving the business. As a result, the calculation can give identical weight to profits recorded early in a project’s life and those recorded years later. Measures such as net present value and internal rate of return approach the timing issue differently. Reviewing cash flow separately can also help a business assess whether it will have enough money available to meet its obligations while the investment is in use.

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Accounting Rate of Return vs. Required Rate of Return

ARR provides a projected accounting result for the project under review. Required Rate of Return (RRR) is a separately established target. It reflects how much return would make taking on the investment’s risk acceptable.

The two measures can be considered together even though they perform separate functions. ARR provides a project-specific result, while RRR provides a standard against which an investment can be judged. RRR can also be incorporated into calculations that convert future amounts into present-day values.

Neither figure should automatically settle the decision. ARR can look favorable even when a project requires substantial cash early and produces its strongest results much later. A required return also depends on assumptions about risk and the alternatives available for the same capital.

How to Put ARR to Work Before Spending Money

ARR becomes more useful when you test the assumptions behind the percentage instead of treating the result as a yes-or-no signal. Write down the purchase price, expected life of the asset, residual value, additional revenue, and expenses associated with the investment. This gives you a set of inputs that you can revise as circumstances change.

Suppose your first estimate produces a 16% ARR. Recalculate it after reducing projected revenue by 10% or increasing annual expenses by a similar amount. If a relatively small change pushes the return below the level you would accept, the investment has less room for disappointing results than the original 16% figure suggests.

Your next calculation should focus on actual dollars moving in and out of the business. List the cash required at purchase, any loan payments, maintenance costs, and other ongoing expenses. Then estimate when additional cash from the investment is likely to arrive. This separate exercise can identify periods when the purchase could put pressure on your available funds even when its ARR looks attractive.

For competing projects, use a consistent ARR calculation so the percentages are based on comparable inputs. Then examine the dollar commitment, financing requirements and expected duration of each option. A project with the larger percentage may still be less appealing when it absorbs substantially more capital or restricts money that could be used elsewhere in the business.

A financial advisor can help you compare the expected return from a business investment with other ways you could use the same capital.

Bottom Line

ARR offers a relatively simple accounting-based view of a proposed investment, but the percentage leaves out important information about when financial benefits occur. Businesses can use it as one screening measure while separately reviewing liquidity, project timing and other ways the same capital could be deployed.

Tips for Evaluating Capital Investments

Consider working with an experienced financial advisor if you are evaluating a proposed investment. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If the ARR calculation of a proposed capital investment or acquisition looks weak, it might make more sense to outsource. Outsourcing is a complicated issue so it’s good to have grasped the basic arguments for and against outsourcing before you take that alternative step.