This method of evaluating business investments considers the profitability of a project based on accrual accounting amounts found in the financial statements. The drawback of the accounting rate of return is that the net income amounts are not adjusted for the time value of money. In other words, $10,000 of net income in Year 4 is considered to be as valuable as $10,000 of net income in Year 1.
A fairly simple way of gauging your return on an investment in a major project or purchase is the accounting rate of return (ARR). The formula is:
For purposes of this formula, depreciation is calculated very simply, using the straight-line method:
As an example of how ARR works, let’s say you’re looking at equipment costing $7,500 that is expected to return roughly $2,000 per year for five years. After five years you’ll sell the equipment for $500. The depreciation would be ($7,500 – $500) ÷ 5, or $1,400.
Using ARR can give you a quick estimate of the project’s net profits, and can provide a basis for comparing several different projects. Under this method of analysis, returns for the project’s entire useful life are considered (unlike the payback period method, which considers only the period it takes to recoup the original investment). However, the ARR method uses income data rather than cash flow and it completely ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.