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The Accounting Rate of Return (ARR) is a way of calculating the net income expected from an investment or asset in comparison with the initial amount you need to invest.
The ARR is typically used for budgeting by calculating the average annual profit you expect over the life of an investment, compared with the average amount of capital invested. Ergo, helping to determine whether going ahead or continuing with the investment, be it a project or acquisition, is the right decision for your business finances.
What is the Accounting Rate of Return (ARR) formula?
ARR = average annual profit ÷ average investment × 100
As a simplified explanation; if for example, a project requires an average investment of £100,000 and the annual net profit is expected to be £20,000, the ARR would be 20 per cent.
The ARR is widely used to provide a rough guide to how attractive an investment is. The main advantage is that it is easy to understand. The higher the ARR, the more attractive the investment is.
This however, doesn’t take all factors into consideration necessary to make the most accurate calculation possible, therefore it’s important to include some more information when using the formula. Below we show you how to put that into practice and actually work out the profitability of your investments.
How to accurately calculate Accounting Rate or Return
Step 1. Calculate the annual net profit of the investment. This is the remaining revenue when the associated taxes, expenses and interest of the project or investment have been deducted.
Step 2. Work out the depreciation expense if the investment is a fixed asset, such as a property.
Step3. To reach the final figure for annual net profit, you need to subtract the depreciation expense from the annual revenue figure.
Step 4. Lastly, divide the annual net profit by the initial cost of the asset or project, then multiply by 100 to get the percentage.
Example Accounting Rate of Return Calculation
Below we have provided an example of the Accounting Rate of Return formula in action.
A company would like to invest in new fleet of vehicles for the business. The vehicles cost £120,000 and would increase the company’s annual revenue by £39,500, as well as the company’s annual expenses by £10,000. The vehicles are estimated to have a useful shelf life of 20 years, with no salvage value. So, the ARR calculation is as follows:
1. Average annual profit = £39,500 - £10,000 = £29,500
2. Depreciation expense = £120,000 / 20 = £6,000
3. True average annual profit = £29,500 - £6,000 = £23,500
4. ARR = £23,500 / 120,000= 0.1958 = 19.58%
So, in this example, for every pound that your company invests, it will receive a return of19.58p. That’s relatively good, and if it’s better than the company’s other growth or investment plans, it may convince them to go ahead with the investment.
Disadvantages of the accounting rate of return
Points for consideration when using the accounting rate of return are:
- Unlike other methods of investment appraisal, the ARR is based on profits rather than cashflow. It is affected by subjective, non-cash items.
- The ARR also fails to consider the timing of profits. In calculating ARR, £100,000 profit five years away is given just as much weight as a £100,000 profit next year. In reality, you would prefer to get the profit sooner rather than later.
- There are also several different formulas that can be used to calculate an ARR. If you use the ARR to compare different investments, you must be sure that you are calculating the ARR on a consistent basis.
If you’re making along-term investment in an asset or project, it’s important to keep a close eye on your plans and budgets. Accounting Rate of Return (ARR) is one of the best ways to calculate the potential profitability of an investment, making it an effective means of determining which capital asset or long-term project to invest in.
How do you know when to invest?
One thing is for sure when calculating the return of investments is that consistency is key. When comparing the potential return of investments, be sure to use the same formula, there are many variations out there. We also advise speaking to a trusted accountant before committing to any kind of major future investment tied to your company as it could severely impact profits if not both strategically and carefully planned.
If you would like to find out more about how to invest in your best interests, please get in touch with us. Equally, if you have your eye on an investment or have plans for expansion and would like a second option, we would be more than happy to help.
At Blue Rocket Accounting, our expert accountants can not only calculate your best investment option but can advise on the best timings and even other options you may not have considered. We can also connect you with other businesses in our network who can make your dream come to fruition by increasing the net profit of the investment by reducing the costs.
Speak to Blue Rocket Accounting today on 01322 555442 or email happytohelp@bluerocketaccounting.com
