Accounting Business Reporting for Decision Making

CHAPTER 12 Capital investment 505

12.2 Accounting rate of return

LEARNING OBJECTIVE 12.2 Describe and apply the concept of the accounting rate of return (ARR).

The accounting rate of return (ARR) is a simple measure, which has immediate appeal to accountants

and managers who are accustomed to dealing with profit figures and asset values. This measure expresses

the average profit over the period of the investment as a percentage of the average investment. Thus, it

uses the same methodology as the familiar return on assets (ROA) measure, which was discussed in

chapter 8. ROA is, of course, a historical measure, while the ARR involves projected future values.

The ARR is calculated as follows:

ARR =

Average profit

Average investment

Illustrative example 12.2 demonstrates the application of the ARR equation to Coconut Plantations

Pty Ltd.

ILLUSTRATIVE EXAMPLE 12.2

Calculating the ARR

The cash flows (net of cash expenses) given in the Coconut Plantations information in illustrative

example 12.1 are not profits for each year. The cost of using up the value of the equipment or depreci-

ation must be considered. The value of equipment used up is $60 000 ($120 000 – $60 000). Depreciation

of $60 000 for the four-year period, or $15 000 per year, must be deducted to arrive at profits before

tax. The ARR for the Coconut Plantations contract is as follows. (The figures on the top line are in thou-

sands, as are the figures on the bottom line, so we can ignore the thousands in our calculations.) The

average investment in the equipment is the average of the values initially, and at the end of four years;

that is, the average of $120 000 and $60 000.

ARR =

Average profit

=

($30 + $60 + $50 + $40 – $60

4

=

30

= 33.3%

Average investment ($120 + 60)^90

2

Having calculated this rate of return, manufacturers may think the contract offered by Coconut Plan-

tations looks like a pretty good deal. What also must be considered in this case is the opportunity cost

of the manufacturers’ labour. Opportunity cost is the cost of forgoing benefits that otherwise would be

available had the manufacturer not spent time manufacturing the coconut oil. If the manufacturer could

earn $20 000, on average, every year for manufacturing other products in this time, or working for other

people, then the average profit would fall to $10 000 and the ARR to 11.1 per cent.

Decision rule for ARR

The decision rule associated with the ARR varies among entities. Most entities accept the investment

with the highest ARR at the time; they set a minimum level (their required rate of return (RRR)), below

which they will not consider investing. How the RRR is set varies. Some entities base the level on their

own past performance, others look to industry averages, and still others compare the estimated ARR

with currently available yields or returns from other investments outside their industries.

Advantages and disadvantages of ARR

The advantages of the ARR measure are that it is:

• simple to calculate


• easy to understand