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How to calculate Accounting Rate of Return?
The Accounting Rate of Return is an annual percentage of the average net income an asset is estimated to generate divided by the average capital cost. It is used in capital budgeting decisions in situations where companies decide whether to invest or not in an asset-based on net future earnings compared to the capital cost.
The Accounting Rate of Return is a measurement of future profitability more than the assessment of risks. It deals with the required rate of return which is the minimum return an investor seeks than the risks associated with the particular investment.
The Accounting Rate of Return is also known as the simple rate of return, as it does not consider the time value of money that states that a certain amount of money in the present is more valuable than the same amount of money in the future.
Formula to Calculate ARR
The formula to calculate ARR is −
$$\mathrm{ARR =\frac{Average\:Annual\: Profit}{Average \:Investment}}$$
Where,
$$\mathrm{Avg. Annual\:Profit =\frac{Total \:Profit\: over \:Investment\: Period}{Number \:of \:Years}}$$
$$\mathrm{Avg. Investment =\frac{BV \:at \:Year\: 1 + BV\: at \:the\: End \:of \:Useful \:Life}{2}}$$
Calculation of ARR
Following are the steps to calculate the Accounting Rate of Return −
The first step in calculating the ARR is to calculate the average annual profit of the investment. The figure should show the net income the asset will generate, minus any annual costs or expenses like levied taxes or COGs.
The next step is to subtract the depreciation expense. If the investment is made on a fixed asset (like new machinery, property, and other equipment), the net profit would need to be adjusted for the value of depreciation of the asset over the net useful lifecycle of the product. The amount of depreciation should be depreciated from the total annual profit to arrive at the net annual profit.
Then, the annual net profit should be divided by the preliminary cost of the asset. The total profit should be taken and divided by the starting cost of the investment.
The last step is to shift the figure to a percentage value. To do this, the figure obtained in the previous step should be multiplied by 100 to arrive at the percentage rate. One can now determine the net percentage rate of return for the investment by multiplying the decimal figure by 100. If the figure obtained in the last step is 0.125, we would multiply it by 100 to arrive at 12.5%. So the net accounting rate of return is 12.5% over the course of a year.
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