The accounting rate of return (ARR) is a capital budgeting tool used to measure the profit or gain that an investor or a company can expect from a capital project or investment. It is the ratio of the total expected annual income or profit to the investment cost. The ratio is multiplied by 100 to express the figure as a percentage.
An investor or a company with more than one investment option can compute the accounting rate of return for each of the capital investment options to determine which among them will yield the highest return. The higher the ARR, the more attractive the investment option could be. Investors can set a benchmark for an investment to merit consideration. For example, they can set the acceptable rate of return at 30%, meaning that an investment option that will give a financial return equal to or greater than 30% can be counted as a suitable investment option.
There are two ways of computing this figure — the original investment method and the average investment method. The original investment method divides the income or profit expected to be earned during the life of the project by the total capital investment for the project or what is known as the original investment — income/original investment cost. The average investment method divides the average inflows or income expected from the project by the average cost of investment in the project — average income/average investment cost. Dividing the original investment by two or by a number that is the midpoint between the original investment cost and its salvage value will yield the average investment cost to be used as the denominator in computing the ARR using the average investment method.
The expected income or profit from an investment that is reflected as the numerator in the accounting rate of return formula is reflected as income before taxes and depreciation, income after taxes and depreciation, income before tax and after depreciation, or income before depreciation and after tax. These four ways of representing the expected income along with the two methods used in computing the return will significantly affect the outcome of the computation of the said ratio. In order to maintain an apples-to-apples comparison of two or more capital investments, extra caution must therefore be exercised in consistently applying the same formula for each project under comparison.
