How to Calculate Accounting Rate of Return

Knowing how to calculate Accounting Rate of Return (ARR) is important in capital budgeting as it is used to determine the appropriateness of a particular investment. When the answer for ARR exceeds a specific rate, which is accepted by the company, then the project will be selected.

Formula to Calculate Accounting Rate of Return (ARR)

ARR can be calculated using the below formula:

calculate accounting rate of return 01

Average Accounting profit is the mean of the accounting income that is expected to earn within the lifetime of the project. Instead of initial investment there are instances where the average investment is used.

The decision to accept or reject a project is based on the value generated in ARR. The project is accepted if the ARR value is equal to or greater than the required rate of return. In mutually exclusive projects, the project that generates the higher ARR is accepted.

Examples to calculate accounting rate of return (ARR)

Following examples illustrate the ways of calculating ARR.

E.g.1: Project A is having an initial investment of $150,000, and it is expecting to generate an annual cash inflow of $40,000 for 5 years. Depreciation is calculated based on the straight line method. The scrap value is about $20,000 at end of the 5th year.
ARR can be calculated as,

How to calculate ARR

E.g.2: Compare the following mutually exclusive projects based on ARR and identify which project is financially feasible to undertake.

How to calculate accounting rate of returnProject A

calculate accounting rate of return 04

calculate accounting rate of return 05

calculate accounting rate of return 06

Since ARR of a project A is higher that of B, it is more favorable than the project B.

There are many advantages and disadvantages of ARR as indicated below:

Advantages of ARR Calculation

  • It is almost similar to the payback period, and this method of investment appraisal is easy to calculate.
  • It helps to identify the profitability factor of the investment.

Disadvantages of ARR Calculation

  • It avoids the time value of money. If ARR is used to compare two projects which have equal initial investments, the project that generates a higher annual income in the later stages will get a higher rank irrespective of the income generated in the beginning.
  • This calculation can be processed in many ways, but in some cases there are problems of consistency.
  • It uses the accounting income other than the information related with cash flows. However, it is not matching for the projects that have a higher maintenance cost as the viability heavily depends on cash flows.

About the Author: admin

Leave a Comment

Related pages

modulus of elasticity in shearcuddle hugwhat are the kinds of adjectiveribose in rna and deoxyribose in dnawhat is the difference between a renewable and nonrenewable resourcestory of the ugly duckling summaryis maltose sugardefinition of orientation in hrmdifference between american bulldog and pitbulldefinition of enthalpy and entropyadp moleculenucleotide vs nucleosideconjunctions coordinating and subordinatingplant macronutrients and micronutrientsdefinition of triple covalent bonddidactic definitionwhat is horatian satirewhat is the difference between chlorophyll and chloroplastthermoplastics and thermosetting plasticsdifference between termite and flying antprofessional jargon examplesdifference between sherbert and sorbetspell madamestory about rapunzeldefine ultimate tensile stressspring roll versus egg rollthe latin origin of the word satire refers todifference longitudinal and transverse wavessugar vs starchnormative vs positive economicsdifference between alaskan husky and siberian huskylead vs led grammardifference moth butterflycougar mountain lion differencesubject and predicate nominativedifference between solenoid and inductorrubeola vs rubelladifferentiate between inhalation and exhalationbinding energy per nucleon equationis cumin and jeera samesarcoma carcinoma differencedifference between maize and corndefinition for centriolesdifference between primary succession and secondary successionthe difference between gymnosperms and angiospermsevaporation and vapourisationcompare and contrast classical and operant conditioningsodium bicarbonate in baking sodaclosed and open vowelswhat is frozen custard vs ice creamshruti definitioncitric acid vitamindifference between sex chromosomes and autosomesthe difference between longitudinal and transverse wavesclassical conditioning vs operant conditioningwhat is a coccuspolyunsaturated vs monounsaturatedhow is hinduism and buddhism alikezygote fetus embryophysical properties of alkanesis ptfe teflongrains and pulseswhat is the difference between phosphorescence and fluorescencecarpe diem poem examplesdifference between dementia and deliriumelements of an expository essayzygote embryo fetuswhat is the difference between micronutrients and macronutrientsdifference between displacement and distance traveledchemical and physical properties of lipidsdifference between imperialism and neo imperialismdefine enunciatemacbeth antagonist