Accounting rate of return

Covers AS91381 Covers AS91379

What it measures

The accounting rate of return (ARR), also called the average rate of return, expresses the investment's return as a percentage of what was spent.
It answers: what does this earn, compared with the money it ties up?
Because it is a percentage, it can be compared directly with other percentages — the interest rate on a term deposit, the cost of borrowing, or the return on a different project.
The rule: higher is better, and the business normally has a minimum it will accept.

How to calculate it

Step 1. Add up the total net cash inflows across the whole life of the investment.
Step 2. Subtract the initial cost to get the total profit over the investment's life.
Step 3. Divide by the number of years to get the average annual profit.
Step 4. Divide the average annual profit by the initial cost and multiply by 100.

Written as a formula:

ARR = (average annual profit ÷ initial cost) × 100

Average annual profit — total inflows minus initial cost, divided by the number of years.
Initial cost — the full amount paid out at the start.

Worked ExampleAccounting rate of return on the same machine

Using the same Kōwhai Coast Packaging figures (invented business, illustrative figures): initial cost $180,000; net cash inflows of $60,000, $70,000, $80,000 and $80,000 over four years.

Find the accounting rate of return.

Step 1 — Total the inflows

60,000 + 70,000 + 80,000 + 80,000 = $290,000

Step 2 — Subtract the initial cost to find total profit over the life

290,000 − 180,000 = $110,000

Step 3 — Find the average annual profit

The machine has a four-year life.

110,000 ÷ 4 = $27,500 per year

Step 4 — Express that as a percentage of the initial cost

(27,500 ÷ 180,000) × 100 = 15.277… = 15.3% (1 d.p.)

ARR = 15.3%

What it means. Every dollar tied up in the machine earns an average of 15.3 cents a year. If Kōwhai Coast can borrow at 8%, the machine earns comfortably more than the borrowing costs, so on this measure it is worth doing.

Advantages

A percentage, so it is comparable — with other projects, with the interest rate, with the cost of finance.
It uses the whole life of the investment, unlike payback.
It measures profitability, which is what shareholders and lenders ask about.
Simple to calculate and widely understood.

Disadvantages

It ignores the timing of the returns. A project earning nothing for three years then a large sum in year four gets the same ARR as one earning steadily — but the second is far more useful to a business that needs cash.
It ignores the time value of money, for the same reason.
It is an average, so it hides variability. Two projects with the same ARR can have very different risk profiles.
It depends on the estimated life. Change the assumed life from four years to five and the answer changes, even though nothing real has changed.
Conventions differ. Some businesses divide by the average investment rather than the initial cost, which produces a different figure. Use the method the question sets out, and state which you used.

What it measures

The accounting rate of return (ARR), also called the average rate of return, expresses the investment's return as a percentage of what was spent.

It answers: what does this earn, compared with the money it ties up?

Because it is a percentage, it can be compared directly with other percentages — the interest rate on a term deposit, the cost of borrowing, or the return on a different project.

The rule: higher is better, and the business normally has a minimum it will accept.

How to calculate it

Step 1. Add up the total net cash inflows across the whole life of the investment.

Step 2. Subtract the initial cost to get the total profit over the investment's life.

Step 3. Divide by the number of years to get the average annual profit.

Step 4. Divide the average annual profit by the initial cost and multiply by 100.

Written as a formula:

ARR = (average annual profit ÷ initial cost) × 100

Average annual profit — total inflows minus initial cost, divided by the number of years.

Initial cost — the full amount paid out at the start.

Disadvantages

It ignores the timing of the returns. A project earning nothing for three years then a large sum in year four gets the same ARR as one earning steadily — but the second is far more useful to a business that needs cash.

It ignores the time value of money, for the same reason.

It is an average, so it hides variability. Two projects with the same ARR can have very different risk profiles.

It depends on the estimated life. Change the assumed life from four years to five and the answer changes, even though nothing real has changed.

Conventions differ. Some businesses divide by the average investment rather than the initial cost, which produces a different figure. Use the method the question sets out, and state which you used.