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What is the Accounting Rate of Return?
The Accounting Rate of Return (ARR) represents the average net income that a company expects to generate from an asset from its capital cost. In other words, it is the return that a company expects on an investment in relation to the initial investment cost. The ARR is often applicable in capital budgeting, where companies need to know the returns they can get on their investments.
While ARR is a decision-making tool for companies, it is not as prevalent in its usages as other techniques such as Net Present Value or Payback Period. Despite that, it is useful in decision-making as it considers accounting profits. It differs in that aspect from other techniques that use cash flows for decision-making instead. Similarly, ARR does not consider the time value of money, unlike other techniques.
What is the Accounting Rate of Return formula?
The ARR formula may differ according to the needs of the company that uses it. Usually, the formula that companies use depends on the information they have available at the time. The basic ARR formula is as follows.
Accounting Rate of Rate = Annual Profit / Initial Investment
Companies may also use the average amount for both parts of the formula. Therefore, companies can also calculate their ARR, using the following formula.
Accounting Rate of Return = Average Net Income / Average Capital Cost
Example
A company, Green Co., is considering investing in a project. The project requires an initial investment of $100,000. Green Co. also forecasts that the project will earn revenues of $200,000 while incurring expenses of $180,000. Therefore, the project’s Accounting Rate of Return will be as follows.
Accounting Rate of Rate = Annual Profit / Initial Investment
Accounting Rate of Rate = ($200,000 – $180,000) / $100,000
Accounting Rate of Rate = 0.20 or 20%
What are the advantages of the Accounting Rate of Return?
ARR has several advantages for companies. Firstly, it is simple to use compared to other capital budgeting techniques. It does not consider the time value of money, which means that the calculations are relatively straightforward. Similarly, it also links with other accounting measures, such as Return on Capital Employed, making it easier to understand.
Companies use ARR to compare various projects and the expected returns from those. Therefore, it is crucial in a company’s decision-making process. It also considers the accounting returns, making it easier to compare with actual profits from the investment.
What are the disadvantages of the Accounting Rate of Return?
Compared to other capital budgeting techniques, ARR has several limitations. Firstly, it does not consider the time value of money, which is crucial for decision-making. Instead of using cash flows, it uses profits, which are easily manipulatable. It also ignores various other critical factors, such as working capital changes.
The ARR does not calculate the absolute gain on a project. Similarly, it does not provide a definitive investment signal, unlike other techniques such as NPV. Overall, ARR has more disadvantages than benefits.
Conclusion
Accounting Rate of Return is a metric that shows the average returns from a project based on the capital investment requirements. ARR is a common technique used in capital budgeting. Companies can calculate the ARR of a project using different formulas. ARR has some advantages, but it has more disadvantages due to being basic.
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