Average Accounting Rate of Return Calculator

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Average Accounting Rate of Return (ARR) Calculator

Average Accounting Rate of Return (ARR) Calculator

Calculate the potential profitability of an asset based on average annual profit and average investment.

Total profit expected over the entire lifespan.

Calculation Results

Average Annual Profit:

$0.00

Average Investment:

$0.00

Accounting Rate of Return (ARR):

0.00%

function calculateARR() { // Retrieve values from inputs var initialInv = parseFloat(document.getElementById('arr_initial_investment').value); var scrapVal = parseFloat(document.getElementById('arr_scrap_value').value); var totalProf = parseFloat(document.getElementById('arr_total_profit').value); var duration = parseFloat(document.getElementById('arr_years').value); var resultSection = document.getElementById('arr_result_section'); // Default scrap value to 0 if empty, other fields require input if (isNaN(scrapVal)) { scrapVal = 0; } // Validation if (isNaN(initialInv) || isNaN(totalProf) || isNaN(duration) || duration <= 0 || initialInv 0) { arrPercentage = (avgAnnualProfit / avgInvestment) * 100; } // Display Results resultSection.style.display = "block"; // Format currency var formatter = new Intl.NumberFormat('en-US', { style: 'currency', currency: 'USD', }); document.getElementById('display_avg_profit').innerHTML = formatter.format(avgAnnualProfit); document.getElementById('display_avg_investment').innerHTML = formatter.format(avgInvestment); document.getElementById('display_arr_percent').innerHTML = arrPercentage.toFixed(2) + "%"; // Interpretation Logic (Simple generic threshold message) var decisionDiv = document.getElementById('display_decision'); if (arrPercentage > 0) { decisionDiv.innerHTML = "This indicates a positive return on the average investment over the project's life."; } else { decisionDiv.innerHTML = "This indicates a negative return or loss on the project."; } }

What is the Accounting Rate of Return (ARR)?

The Accounting Rate of Return (ARR) is a financial ratio used in capital budgeting to estimate the profitability of potential investments. Unlike other metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR), ARR calculates the return generated from net income (accounting profit) rather than cash flow. It does not account for the time value of money, making it a simpler, albeit less precise, method for initial project screening.

Managers use ARR to determine if a project meets a required minimum rate of return. If the calculated ARR is higher than the company's hurdle rate, the project may be accepted.

How to Calculate ARR

There are two main components to the ARR formula: the Average Annual Profit and the Average Investment.

ARR Formula:

ARR = (Average Annual Profit / Average Investment) × 100

  • 1. Average Annual Profit: This is calculated by taking the total expected net profit over the life of the investment and dividing it by the number of years the project will run.
    Formula: Total Net Profit ÷ Number of Years
  • 2. Average Investment: This represents the book value of the asset over its life. Since the asset depreciates from its initial cost down to its scrap value, the average is the midpoint.
    Formula: (Initial Investment + Scrap Value) ÷ 2

Real-World Example Calculation

Imagine a company is considering purchasing a new machine. Here are the details of the proposed project:

  • Initial Investment: $200,000
  • Scrap Value (at end of life): $20,000
  • Total Expected Profit: $90,000
  • Project Duration: 5 Years

Step 1: Calculate Average Annual Profit
$90,000 (Total Profit) ÷ 5 (Years) = $18,000 per year.

Step 2: Calculate Average Investment
($200,000 + $20,000) ÷ 2 = $110,000.

Step 3: Calculate ARR
($18,000 ÷ $110,000) × 100 = 16.36%.

Advantages and Disadvantages of ARR

Advantages

  • Simplicity: It is easy to calculate and understand.
  • Profit Focus: It considers the entire profitability of the project, not just cash flows.
  • Comparison: It allows for easy comparison against a required percentage return.

Disadvantages

  • Time Value of Money: It ignores that a dollar today is worth more than a dollar tomorrow.
  • Cash Flow Ignored: It uses accounting profit (which includes non-cash items like depreciation) rather than actual cash flows.
  • Arbitrary Cut-offs: The acceptable "hurdle rate" is often subjective.

Frequently Asked Questions

Does ARR include Depreciation?

Yes, ARR is based on accounting profit (Net Income), which is calculated after deducting expenses, including depreciation.

What is a good Accounting Rate of Return?

A "good" ARR depends on the company's internal policy, cost of capital, and risk appetite. Generally, an ARR higher than the company's cost of capital or a minimum target (e.g., 12% or 15%) is considered acceptable.

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