Accounting rate of return (ARR)

The accounting rate of return (ARR) is a very simple (in fact overly simple) rate of return:

average profit ÷ average investment

as a percentage.

Where average means arithmetic mean.

The profit number used is operating profit (usually from a particular project).

The average investment is the book value of assets tied up (in the project). This is important as the profit figure used is after depreciation and amortisation. The means that value of assets used should also be after depreciation and amortisation as well.

ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organisation. It is rarely used by investors, and should not be used at all, because:

  • Cash flows are more important to investors, and ARR is based on numbers that include non-cash items.
  • ARR does not take into account the time value of money — the value of cashflows does not diminish with time as is the case with NPV and IRR.
  • It does not adjust for the greater risk to longer term forecasts.
  • There are better alternatives which are not significantly more difficult to calculate.

The accounting rate of return is conceptually similar to payback period, and its flaws, in particular, are similar. A very important difference is that it tends to favour higher risk decisions (because future profits are insufficiently discounted for risk, as well as for time value), whereas use of the payback period leads to overly conservative decisions.

Because ARR does not take into account the time value of money, and because it is wholly unadjusted for non-cash items, any method of selecting investments based on it is necessarily seriously flawed. Its only advantage is that it is very easy to calculate. It is fairly easy to construct (realistic) examples where it will lead to different choices from NPV, and the NPV led decision is clearly correct.

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