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:

  1. 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.
  2. 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.
  3. 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.