Definition:
The accounting rate of return (ARR) method is a financial metric used to evaluate the profitability of an investment. It calculates the average annual net income from an investment as a percentage of the average investment cost.
Formula:
ARR = Average Annual Net Income / Average Investment Cost
How to calculate ARR:
- Determine the average annual net income: Add the net income for each year of the investment’s life and divide by the number of years.
- Calculate the average investment cost: Add the initial investment cost and the salvage value (if any) at the end of the investment’s life and divide by 2.
- Divide the average annual net income by the average investment cost: This will give you the ARR as a percentage.
Why is the ARR method used?
- Simplicity: It’s a relatively simple method to calculate and understand.
- Relates to accounting income: It directly uses the accounting income from the investment.
- Easy to compare with other investments: ARR can be used to compare the profitability of different investment options.
Limitations of the ARR method:
- Doesn’t consider the time value of money: It doesn’t account for the fact that money earned today is worth more than money earned in the future.
- Focuses on accounting income: It relies on accounting income, which may not always reflect the true economic profitability of an investment.
In conclusion, the ARR method provides a basic measure of profitability, but it’s important to consider its limitations and use it in conjunction with other financial metrics.
