Accounting Rate of Return – ARR Definition

The accounting rate of return (ARR) is the percentage rate of return expected on an investment or asset as compared to the initial investment cost. 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. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

$ARR = \frac{Average\, annual\, profit}{Initial\, investment}$ARR=InitialinvestmentAverageannualprofit​

1. Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
2. If the investment is a fixed asset such as property, plant, or equipment, subtract any depreciation expense from the annual revenue to achieve the annual net profit.
3. Divide the annual net profit by the initial cost of the asset, or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

The accounting rate of return is a capital budgeting metric useful for a quick calculation of an investment's profitability. ARR is used mainly as a general comparison between multiple projects to determine the expected rate of return from each project.

ARR can be used when deciding on an investment or an acquisition. It factors in any possible annual expenses or depreciation expense that's associated with the project. Depreciation is an accounting process whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset.

Depreciation is a helpful accounting convention that allows companies not to have to expense the entire cost of a large purchase in year one, thus allowing the company to earn a profit from the asset right away, even in its first year of service. In the ARR calculation, depreciation expense and any annual costs must be subtracted from annual revenue to yield the net annual profit.

A project is being considered that has an initial investment of $250,000 and it's forecasted to generate revenue for the next five years. Below are the details:

• initial investment: $250,000
• expected revenue per year: $70,000
• time frame: 5 years
• ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
• ARR = .28 or 28% (.28 * 100)

As stated, the ARR is the annual percentage return from an investment based on its initial outlay of cash. However, the required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor will accept for an investment or project, that compensates them for a given level of risk.

RRR can vary between investors because investors have different risk tolerances. For example, a risk-averse investor would likely require a higher rate of return from an investment to compensate for any risk from the investment. It's important to utilize multiple financial metrics including ARR and RRR, in determining if an investment is worth it.

The ARR is helpful in determining the annual percentage rate of return of a project. However, the calculation has its limitations.

ARR doesn't consider the time value of money (TVM). The time value of money is the concept that money available at the present time is worth more than an identical sum in the future due to its potential earning capacity. In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Also, ARR does not take into account the impact of cash flow timing. Let's say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn't yield any revenue until the fourth and fifth year. The investor would need to be able to withstand the first three years without any positive cash flow from the project. The ARR calculation would not factor in the lack of cash flow in the first three years.