What is the Formula for ARR, and its Methods to Calculate?

Accounting Rate of Return is one of the easiest methods to calculate return which takes into account the average of net profit and investment. It is also known as the average accounting rate of return. Let’s understand the ARR formula and its calculation in detail.

ARR Formula

We can calculate the accounting rate of return by using the following formula or methods or steps:

ARR = Average Net Profit / Average Investment

Average Net Profit

Here, the average net profit is the profit that the company makes from an investment or a project after deducting all the expenses associated with the project. The expenses will include operating expenses, depreciation, and taxes.

Also, we take the average of the net profits earned over the years during the investment period. To calculate the average net profit, we divide the total profits that the company makes from that project by the number of years into consideration.

Average Investment

Average investment is the investment that includes the initial cost (including installation cost, if any) less scrap value and then divide by 2. Or, book value in the 1st year less book value at the end of its useful life (scrap value) divided by 2.

As we have seen the formula for ARR, let’s understand the formula for ARR and calculation in detail with help of an example

Example

Suppose X ltd. has bought a machine for $1,50,000, and the depreciation is charged on that machine at 20% depreciation on the straight-line method. Let’s calculate the ARR using the data below.

ParticularsYear 1Year 2Year 3Year 4Year 5
Sales 5,00,0004,00,0003,00,0002,00,0001,00,000
-Expenses3,50,0003,30,0001,80,00050,00040,000
-Depreciation (20%)30,00030,00030,00030,00030,000
Earnings before Tax1,20,00020,00090,0001,20,00010,000
– Tax (40%)48,0008,00036,00048,0004,000
Net Income72,00012,00054,00072,0006,000

Average Profit = Net Profit Year 1 + Net Profit Year 2…../ No. of Year

= 72,000+12,000+54,000+72,000+6,000 / 5

=$2,16,000/5

= $43,200

Average Investment = Average Book Value / 2

= (1,50,000 – 0)/2

= 75,000

ARR =$43,200/$75,000 x 100

= 57.6%

So according to this example, our ARR is 57.6%

Is there any Minimum Acceptable Accounting Rate of Return?

Companies and project managers usually set a “hurdle rate” for an investment on the basis of its risk and its risk tolerance before embarking upon any fresh investment. We can call this the minimum rate the company is looking for from any project or investment that it takes up. We also call this minimum rate the “required rate of return” (RRR). The ARR of a project should be higher than the company’s required rate of return for a project to be feasible.

However, the hurdle rate is dynamic in nature and keeps varying depending on the risk involved in the project. Also, the risk tolerance of the company or an investor can also change from time to time. Therefore, there is no minimum acceptable ARR as such. It is also dynamic and keeps changing from one project or investment to other. – {this may be right but may complicate the concept}

The only thing that is a constant and guiding factor is that the ARR should always be above the RRR considering the time, risk and investment.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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