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What is the Accounting Rate of Return?

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  • Written By: Rolando Braza
  • Edited By: J.T. Gale
  • Last Modified Date: 08 September 2016
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The accounting rate of return (ARR) is a capital budgeting tool used to measure the profit or gain that an investor or a company can expect from a capital project or investment. It is the ratio of the total expected annual income or profit to the investment cost. The ratio is multiplied by 100 to express the figure as a percentage.

An investor or a company with more than one investment option can compute the accounting rate of return for each of the capital investment options to determine which among them will yield the highest return. The higher the ARR, the more attractive the investment option could be. Investors can set a benchmark for an investment to merit consideration. For example, they can set the acceptable rate of return at 30%, meaning that an investment option that will give a financial return equal to or greater than 30% can be counted as a suitable investment option.

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There are two ways of computing this figure — the original investment method and the average investment method. The original investment method divides the income or profit expected to be earned during the life of the project by the total capital investment for the project or what is known as the original investment — income/original investment cost. The average investment method divides the average inflows or income expected from the project by the average cost of investment in the project — average income/average investment cost. Dividing the original investment by two or by a number that is the midpoint between the original investment cost and its salvage value will yield the average investment cost to be used as the denominator in computing the ARR using the average investment method.

The expected income or profit from an investment that is reflected as the numerator in the accounting rate of return formula is reflected as income before taxes and depreciation, income after taxes and depreciation, income before tax and after depreciation, or income before depreciation and after tax. These four ways of representing the expected income along with the two methods used in computing the return will significantly affect the outcome of the computation of the said ratio. In order to maintain an apples-to-apples comparison of two or more capital investments, extra caution must therefore be exercised in consistently applying the same formula for each project under comparison.

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anon253889
Post 3

Thanks very much. Appreciate the clarity in the explanation.

Oski
Post 2

@YogurtPark - I am glad you brought up that point. A similar situation happened to a company I used to work for.

We made children's toys, and we decided to invest millions of dollars into make a new action figure. The Spider Man movies were coming out, so we thought we could capitalize on the growing interest in super heroes.

Our marketing team incorrectly estimated the sales of our product. They thought that the toy would sell better than it actually did. To make matters worse, we spent more money than we had planned manufacturing the toy. After all the money we spent on production and advertising, we ended up losing money. In retrospect, our accounting rate of return was a decimal figure, meaning that we made less money than we invested.

YogurtPark
Post 1

Thanks for writing this article. The information presented is clear and precise. I am sure plenty of people will learn from it.

I have been working as an accountant for years. One thing that I would add is, it is important to realize that the accounting rate of return is based on an estimate, so it should be treated as such. Investors should always use an ARR with caution when making an investment decision.

The reason I say that is because the estimated income that an investment is supposed to generate may not be accurate in reality. For example, suppose a company wants to invest in manufacturing equipment to make a new product. If the product does not sell as well as the company expected it would, then money might be lost.

For the most part ARRs can be used to make wise investment decisions. But other factors should be considered before the investment is made.

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