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Accounting Rate of Return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting
profit of a project to the average investment made in the project. ARR is used in investment
appraisal.

Formula
Accounting Rate of Return is calculated using the following formula:

ARR =

Average Accounting Profit

Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR formula
uses initial investment instead of average investment.

Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of return.
In case of mutually exclusive projects, accept the one with highest ARR.

Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of
return assuming that there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years
Annual Depreciation = ($130,000 $10,500) 6 $19,917
Average Accounting Income = $32,000 $19,917 = $12,083
Accounting Rate of Return = $12,083 $130,000 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:

Year
Cash Outflow

91

130

105

-220

Cash Inflow
Salvage Value

10

Project B:

Year
Cash Outflow

0
-198

Cash Inflow

87

110

Salvage Value

84
18

Solution
Project A:

Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70

Step 2: Year
Cash Inflow

91

130

105

Salvage Value
Depreciation*

10
-70

-70

-70

Accounting Income 21
60
45
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3
= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:

Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60

Step 2: Year
Cash Inflow

87

110

84

Salvage Value
Depreciation*

18
-60

-60

-60

Accounting Income 27
50
42
Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3
= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 20.0%
Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages

Advantages
1.

Like payback period, this method of investment appraisal is easy to calculate.

2.

It recognizes the profitability factor of investment.

Disadvantages
1.

It ignores time value of money. Suppose, if we use ARR to compare two projects having equal
initial investments. The project which has higher annual income in the latter years of its useful
life may rank higher than the one having higher annual income in the beginning years, even if
the present value of the income generated by the latter project is higher.

2.

It can be calculated in different ways. Thus there is problem of consistency.

3.

It uses accounting income rather than cash flow information. Thus it is not suitable for projects
which having high maintenance costs because their viability also depends upon timely cash
inflows.

If you have already studied other capital budgeting methods (net present value method, internal rate
of return method and payback method), you may have noticed that all these methods focus on cash
flows. Butaccounting rate of return (ARR) method uses expected net operating income to be
generated by the investment proposal rather than focusing on cash flows to evaluate an investment
proposal.
Under this method, the assets 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
managements desired rate of return to accept or reject a proposal. If the assets expected accounting
rate of return is greater than or equal to the managements desired rate of return, the proposal is
accepted. Otherwise, it is rejected. The accounting rate of return is computed using the following
formula:
Formula of accounting rate of return (ARR):

In the above formula, the incremental net operating income is equal to incremental revenues to be
generated by the asset less incremental operating expenses. The incremental operating expenses
also include depreciation of the asset.
The denominator in the formula is the amount of investment initially required to purchase the asset. If
an old asset is replaced with a new one, the amount of initial investment would be reduced by any
proceeds realized from the sale of old equipment.

Example 1:
The Fine Clothing Factory wants to replace an old machine with a new one. The old machine can be
sold to a small factory for $10,000. The new machine would increase annual revenue by $150,000
and annual operating expenses by $60,000. The new machine would cost $360,000. The estimated
useful life of the machine is 12 years with zero salvage value.
Required:
1. Compute accounting rate of return (ARR) of the machine using above information.
2. Should Fine Clothing Factory purchase the machine if management wants an accounting rate of
return of 15% on all capital investments?

Solution:
(1): Computation of accounting rate of return:

= $60,000* / $350,000**
= 17.14%
*Incremental net operating income:
Incremental revenues Incremental expenses including depreciation
$150,000 ($60,000 cash operating expenses + $30,000 depreciation)
$150,000 $90,000
$60,000
** The amount of initial investment has been reduced by net realizable value of the old machine
($360,000 $10,000).
(2). Conclusion:
According to accounting rate of return method, the Fine Clothing Factory should purchases the
machine because its estimated accounting rate of return is 17.14% which is greater than the
managements desired rate of return of 15%.

Cost reduction projects:

The accounting rate of return method is equally beneficial to evaluate cost reduction projects. The
accounting rate of return of the assets that are purchased with a view to reduce business costs is
computed using the following formula:

Example 2:

The P & G company is considering to purchase an equipment costing $45,000 to be used in packing
department. It would reduce annual labor cost by $12,000. The useful life of the equipment would be
15 years with no salvage value. The operating expenses of the equipment other than depreciation
would be $3,000 per year.
Required: Compute accounting rate of return/simple rate of return of the equipment.

Solution:

= $6,000* / $45,000
= 13.33%
*Net cost savings:
$12,000 ($3,000 cash operating expenses + $3,000 depreciation expenses)
$12,000 $6,000
$6,000

Comparison of different alternatives:

If several investments are proposed and the management have to choose the best due to limited
funds, the proposal with the highest accounting rate of return is preferred. Consider the following
example:

Example 3:
The Good Year manufacturing company has the following different alternative investment proposals:
Proposal A

Proposal B

Proposal C

Expected incremental income per year (a)

$50,000

$75,000

90,000

Initial investment (b)

$250,000

$300,000

$500,000

20%

25%

18%

Expected accounting rate of return (a)/(b)

Required: Using accounting rate of return method, select the best investment proposal for the
company.

Solution:
If only accounting rate of return is considered, the proposal B is the best proposal for Good Year
manufacturing company because its expected accounting rate of return is the highest among three
proposals.

Advantages and disadvantages:

Advantages:
1. Accounting rate of return is simple and straightforward to compute.
2. It focuses on accounting net operating income. Creditors and investors use accounting net operating
income to evaluate the performance of management.

Disadvantages:
1. Accounting rate of return method does not take into account the time value of money. Under this
method a dollar in hand and a dollar to be received in future are considered of equal value.
2. Cash is very important for every business. If an investment quickly generates cash inflow, the
company can invest in other profitable projects. But accounting rate of return method focus on
accounting net operating income rather than cash flow.
3. The accounting rate of return does not remain constant over useful life for many projects. A project
may, therefore, look desirable in one period but undesirable in another period.