Investing in long-term assets or projects demands diligent monitoring of your plans and budgets. One effective method for assessing the potential profitability of an investment is using the Accounting Rate of Return (ARR). This metric can guide you in choosing the most viable capital asset or long-term project for your investment.
The Accounting Rate of Return is a metric that estimates the expected net income from an investment compared to its initial cost. It's particularly handy for making decisions related to capital budgeting. For instance, if your business is contemplating whether to proceed with an investment, such as a project or acquisition, ARR provides a quantitative basis to decide if it's a financially sound choice.
Formula for Accounting Rate of Return (ARR)
The formula for ARR is quite straightforward:
ARR = Average Annual Profit / Average Investment
However, to make practical use of this formula, you need to understand how to determine the profitability of your investments.
Calculating ARR is a straightforward process. Follow these steps:
- Determine the Annual Net Profit: Start by calculating the annual net profit from your investment. This is the revenue left after deducting all operating costs, taxes, and interests related to the investment or project.
- Account for Depreciation: If the investment involves a fixed asset, like property, factor in the depreciation expense.
- Calculate the Final Annual Net Profit: Deduct the depreciation expense from your annual revenue to find the final net profit.
- Compute ARR: Divide the annual net profit by the initial cost of the asset or investment. The result will be in decimal form. Multiply by 100 to convert it into a percentage return.
Various online ARR calculators are available for those who prefer not to calculate ARR manually. EasyCalculation, for example, offers a simple tool to compute ARR, among other available options online. These calculators can help ensure your calculations are accurate.
Example of ARR Calculation
Let's take a practical example to understand better the rate of return accounting calculation.
A company is contemplating investing in a new manufacturing machine. The machine costs £500,000. This equipment should boost output by £150,000 per year, according to the business. It will also raise annual operational expenses by £20,000. No salvage value is envisaged after the machine's 10-year lifespan.
ARR Calculation Steps
Calculate Average Annual Profit
Additional Revenue: £150,000
Additional Operating Costs: £20,000
Average Annual Profit = £150,000 - £20,000 = £130,000
Determine Depreciation Expense
Total Cost of Machine: £500,000
Useful Life: 10 years
Depreciation Expense = £500,000 / 10 = £50,000 per year
Compute True Average Annual Profit
Average Annual Profit: £130,000
Depreciation Expense: £50,000
True Average Annual Profit = £130,000 - £50,000 = £80,000
Calculate ARR
ARR = £80,000 / £500,000 = 0.16 or 16%
In this example, the company would get a return of 16p for every pound invested in the new manufacturing machine. This 16% ARR would be compared against the company's target return or other investment opportunities to determine whether it is worthwhile.
Calculating ARR in Excel
Excel Setup
In cell A1, type 'Year.'
In cells C1 to L1, enter the years (1 through 10 for a ten-year project).
In cell A2, type 'Net Income.'
In cells C2 to L2, input £80,000 (the net annual income) each year.
In cell A3, type 'Initial Investment.'
In cell B3, enter £500,000 (the initial investment amount).
In cell A4, type 'Salvage Value.'
In cell B4, you can enter £0 or leave it blank, as there is no salvage value.
ARR Calculation in Excel
In cell A5, type 'ARR.'
In cell B5, input the formula =AVERAGE(C2:L2)/B3.
Press Enter to see the ARR in cell B5, which should reflect 16%.
This Excel method provides a clear and efficient way to track and calculate the ARR for the new investment. Remember, you might need to adjust the details based on your project's specifics. For instance, if your project spans over five years, you should extend the range accordingly. This Excel method offers a straightforward and effective way to calculate ARR for any investment.
Pros and Cons of the ARR
Pros
The Accounting Rate of Return (ARR) stands out for its simplicity and ease of calculation, avoiding the need for complex mathematical operations. It is a useful tool for evaluating a project's annual rate of return accounting. This simplicity enables managers to straightforwardly compare the ARR of a project to the minimum return threshold they've set. For instance, if a project must meet at least a 12% return but the calculated ARR is only 9%, it becomes clear that it falls short of financial expectations.
ARR is particularly beneficial when investors or managers are looking to assess the return of a project swiftly. It focuses on profitability, setting aside considerations like the returns' time frame or payment schedules.
Cons
However, ARR is not without its limitations. A significant drawback is its disregard for the time value of money. This concept suggests that money currently available is more valuable than the same amount in the future due to its potential earning power.
This oversight can be problematic when different investments yield varying annual revenues. For example, suppose one project delivers higher returns in earlier years and another yields returns later. In that case, the ARR does not prioritize the project with earlier returns, which could be reinvested for additional gains. Thus, ARR may not always reflect the most financially strategic choice.
Comparing ARR with Required Rate of Return (RRR)
While ARR calculates the annual percentage return based on the initial investment, the Required Rate of Return (RRR), or hurdle rate, represents the minimum return an investor expects from a project to justify its risks. It varies among investors, reflecting their risk tolerances. For instance, risk-averse investors typically look for a higher RRR to offset perceived risks.
It's crucial to employ a combination of financial metrics, including ARR and RRR, to make a well-rounded decision. This approach ensures that investments align not only with profitability expectations but also with individual risk preferences.
The Bottom Line
Investors and managers use the simple ARR Accounting Rate of Return to assess asset or project profitability. Its simplicity makes it a useful decision-making tool. However, ARR doesn't account for investment cash flows, return timelines, and other expenses. These factors are key in understanding the true value of an investment or project, underscoring the importance of using ARR as part of a broader set of financial evaluation tools.
