Understanding ARR
Businesses are faced with the need to expand their portfolio every day. All these pursuits must be analyzed to determine whether they lead to profits or losses. The Accounting Rate of Return formula, also known as the Average Rate of Return, is technique business owners use to ascertain a project’s potential to make profits.
It provides a snapshot of a particular investment saving an investor from allocating funds blindly into a venture that may seem profitable when it’s not. This technique is less fixated on the required rate of return, which is the minimum amount of profits a business seeks.
ARR Definition
ARR is a technique for capital budgeting calculated to determine the potential profit of long-term investment or project that lasts over a while. It uses the average of yearly revenues realized by a firm’s assets divided by the initial cost. ARR generates a decimal figure multiplied by a hundred to get the percentage rate.
Accounting Rate of Return Formula
The Accounting Rate of Return is calculated using the following formula:
| ARR = Average Annual Profit ÷ Average Investment |
Steps of calculating the accounting rate of Return
Step 1. Calculating the average profits generated annually
This figure represents the annual income received and subtracts any expenses incurred. These expenses or costs may include taxes or the cost of goods sold.
Example:
A company owns an asset generating a yearly income or net present value of $200,000, generating $100,000 as revenue. The asset costs the company an amount to a tune of $25000 in repairs to walls and drainage system, reducing the annual net profit of the year to $75,000. The annual profit is calculated below by dividing the net annual profit by the number of years, in this case, one.
| $75,000 ÷ 1= 75,000 |
If the asset is to be sold off at the end of the financial year, the asset’s residual or scrap value is to be included in the net annual profit.
Step 2. Deducting any depreciation
A company’s fixed assets, like newly bought machines, need to be adjusted at the end of the financial year to determine the amount of depreciation and the net profit throughout usefulness. Depreciation is subtracted from the annual profit to generate a net annual profit.
Example:
Proceeding with the step above, the depreciation for the building, which was valued at $200,000, is $50,000. Thus the net annual profit will be:
| $75,000 – $50,000 = $25,000 |
Step 3. Dividing the net annual profit figure by the earlier cost of the asset
In this step, the profit is divided by the cost incurred at the purchase of the project, in this case, the buildings. Following our earlier example, this will be:
| $25,000 ÷ $200,000 = 0.125 |
Step 4. Generating the percentage.
The decimal figure generated from step 3 is then multiplied by 100 to get the percentage rate of the investment, as shown below:
| 0.125 × 100 = 12.5% |
This means the asset would generate a net 12.5% income over one year the company will use it. 12.5% is the Accounting Rate of Return for that asset.
ARR Example:
A company intends to invest in a project of a fleet of motor vehicles whose shelf life is 20 years. These vehicles cost $350,000 and would generate $100,000 in profits and increase the expenses to $10,000 during their useful life. Calculate the Accounting Rate of Return for the investment without any salvage value.
Solution:
Calculating the average annual profit:
| $100,000 – $10,000 = $90,000 |
The depreciation expenses:
| $350,000 ÷ 20 = $17,500 |
Correct annual average net profit:
| $90,000 – $17,500 = $72,500 |
Calculating the accounting rate of return:
| ARR = Average Annual Profit ÷ Average Investment |
| $72,500 ÷ $350,000 = 0.2071 |
| 0.2071 × 100 = 20.71% |
The fleet of vehicles is expected to generate an ARR of 20.71 % for their useful life.
What Is a Good Accounting Rate of Return?
If the calculation result is equal to or greater than 1, the project is viable for investment (acceptable). For multiple projects, the one with the highest ARR is chosen to be invested in. The calculations are normally done before choosing and may be executed year after year since ARR cannot cater to multiple variables.
