What Is the Accounting Rate of Return? How to Calculate ARR

Accounting rate of return (ARR) is a capital budgeting formula that is used to determine the potential profitability of long-term investments over a period of time. The ARR formula takes the average yearly revenue generated by an asset, then divides that figure by the initial cost. This decimal figure is then multiplied by 100 to yield the percentage rate of return.

Accounting rate of return gives a business a snapshot of the potential earning power of a particular investment. It is less targeted toward risk assessment than the required rate of return (or RRR), which states a minimum profit that an investor seeks. Accounting rate of return is also referred to as the simple rate of return, because it does not consider the time value of money, which assumes that money earned in the present is more valuable than the same amount of money earned in the future.

Companies use the accounting rate of return to assess various capital budgeting decisions or investment opportunities. It is a method of accounting profits by taking the initial valuation of an investment, and adjusting for the cash outflows associated with owning the asset. Before a business commits to a particular capital investment, they may use ARR to determine the potential cash flow that an asset or investment can bring in. They also may use this calculation to determine if an investment they have already made was a wise choice.

Accounting rate of return is a simple formula that any business can use to assess the potential profit of an asset. The ARR formula is “average annual revenue”/ “initial investment.” Keep in mind that each figure should have its own line item, and spreadsheet templates in excel can organize the figures. Here is an example of an ARR calculation.

1. 1. Calculate the average annual profit of the investment. This figure should represent the net income that your asset will generate, minus any annual costs or expenses like taxes or COGs. For example, your asset may be a rental property that has a net present value of $200,000 which has generated $100,000 in revenue. However, if the asset has cost the company $25,000 in repairs (which are your operating expenses), the annual net profit for that particular year would be $75,000. To determine the average annual profit, simply divide the net profit by the investment period or the number of years that you will be using the asset for revenue. For the purpose of our example, we will be looking at the ARR of our asset for one year: $75,000/1 = $75,000. Keep in mind that were we to sell off the asset at the end of the investment period, that amount (the asset’s ‘scrap value’) would be included in our net annual profit.
2. 2. Subtract the depreciation expense. If the investment is a fixed asset (like a new machine, real estate, and other equipment), you need to adjust your net profit for the value depreciation of the asset over the useful life of the product. Subtract the amount of depreciation from your annual profit to arrive at the net annual profit. If the rental property (from the example above) was purchased for $200,000 at the beginning of the year, but now has been valued at $150,000, the annual net profit will be $25,000 ($75,000 - $50,000).
3. 3. Divide the annual net profit by the initial cost of the asset. Take the total profit and divide by the initial cost of the investment—which, in the case of our example, is the $200,000 used to purchase the property. $25,000/$200,000 = 0.125
4. 4. Multiply by 100 to arrive at the percentage rate. Now, you can determine the percentage rate of return for your investment by multiplying your decimal figure by 100. Using our example, we would simply multiply 0.125 by 100 to arrive at 12.5%. This means that our rental property would net a 12.5% internal rate of return over the course of a year.

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