How to Calculate Average Rate of Return (ARR) in Accounting - Simple Guide with Examples
Average Rate of Return Definition
The Average Rate of Return (ARR) is a financial metric used to evaluate the expected profitability of an investment or project.
It measures the average annual profit generated by an investment as a percentage of the initial or average investment cost.
Its simplicity makes it a popular choice, especially for small businesses and individuals looking for a quick assessment tool that helps businesses determine whether a project is worth pursuing.
It can be applied to various types of investments such as:
- Capital Expenditure (such as new machinery or equipment)
- Real Estate Projects
- Stock Portfolios
Formula for Average Rate of Return
The formula for calculating the Average Rate of Return is:
ARR = [Average Annual Profit / Initial Investment] × 100
In some cases, the formula may be adjusted to use the average investment value rather than the initial investment:
ARR = [Average Annual Profit / Average Investment] × 100
Where:
Average Annual Profit = This is the total profit from the investment divided by the number of years the investment is held.
Initial Investment = The upfront cost of the investment or project.
Average Investment = This is the average of the initial investment and the residual value (or salvage value) of the asset.
Examples of Average Rate of Return Calculations
Let’s look at two examples to see how ARR can be calculated in practice.
Example 1: Simple ARR Calculation
Assume a company is considering purchasing a new machine for £80,000.
The machine is expected to generate an annual profit of £5,000 over the next 5 years.
To calculate the ARR:
Initial Investment = £80,000
Average Annual Profit = £5,000
ARR = [Average Annual Profit / Initial Investment] × 100
ARR = [£5,000 / £80,000] × 100 = 6.25%
Therefore, the ARR for this investment is 6.25%, which suggests that the machine would generate an average return of 6.25% per year on the initial investment.
Example 2: ARR Using Average Investment
Assume another company invests £150,000 in a new project which is expected to run for 4 years.
The project is expected to generate £15,000 in annual profit for the first 2 years, then £5,000 in annual profit for the final 2 years.
At the end of the 4 years, the project is expected to have a residual value of £30,000.
The company decides to calculate the ARR using the average investment method:
Initial Investment = £150,000
Residual Value = £30,000
To calculate the average investment:
Average Investment = [Initial Investment + Residual Value] / 2
Average Investment = £150,000 + £30,000 / 2 = £90,000
To calculate the average annual profit:
Total profit over 4 years = [£15,000 × 2] + [£5,000 × 2] = £40,000
Average Annual Profit = Total Profit / Number of Years
Average Annual Profit = £40,000 / 4 = £10,000
We can now calculate the ARR:
ARR = [Average Annual Profit / Average Investment] × 100
ARR = [£10,000 / £90,000] × 100 = 11.11%
Therefore, the ARR for this project is 11.11%.
What is a Good Average Rate of Return?
A “good” ARR is subjective, and depends on the type of investment, risk tolerance and industry standards.
Here’s a guide to what might be considered a good ARR for different contexts:
Investment Type | Good ARR Range | Description |
Low-Risk (Savings Accounts, Bonds) | 2% – 5% | Conservative investments with steady returns and low risk. |
Moderate-Risk (Real Estate) | 5% – 15% | Higher returns expected to offset moderate risk; depends on location and market. |
Stock Market Investments | 7% – 10%+ | Reflects long-term average returns; can vary greatly based on market conditions. |
High-Risk (Venture Capital) | 15% – 25%+ | Startups or risky ventures demand higher returns to justify the risk involved. |
Corporate Project Benchmark | 10% – 15% | Common threshold for internal projects in many industries. |
Advantages of Average Rate of Return
Simplicity
One of the main reasons that ARR is so widely used is its straightforward calculation and interpretation.
Small business owners, managers, and individual investors can easily use ARR without needing advanced financial tools or expertise.
Its simplicity also allows for quick decision making, which is particularly useful in fast paced business environments.
Comparison
Calculating the average rate of return helps businesses compare the benefits of different projects and choose the most profitable ones.
For example, by calculating the ARR for two options, a business can pick the one with the higher return to maximise financial gains.
Disadvantages of Average Rate of Return
Ignores the Time Value of Money
One of the key drawbacks of ARR is that it disregards the time value of money, which is a key concept in finance.
Unlike metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR), ARR does not discount future earnings to their present value.
This means that ARR treats all profits equally, regardless of when they are earned.
In reality, money earned sooner is more valuable because it can be reinvested or used for other opportunities.
As a result, ARR may overestimate the attractiveness of projects with long term profits while undervaluing those with earlier returns.
Based on Accounting Profit
ARR is calculated using accounting profit rather than actual cash flows, which can misrepresent the actual financial picture of a project.
Accounting profit includes non-cash items, such as depreciation and amortisation that don’t directly impact the cash available to the business.
Projects that look appealing based on ARR might struggle with cash flow issues, posing potential risks to the business.
No Consideration for Risk
Another limitation of ARR is its inability to account for the risk associated with an investment.
All projects are treated equally in terms of risk, regardless of how likely they are to succeed or fail.
This can make ARR less reliable when comparing projects with different risk profiles.
For example, a high risk project with an attractive ARR might be chosen over a lower risk project with a slightly lower ARR, potentially exposing the business to unnecessary problems.
ARR vs Other Investment Metrics
ARR is just one of many metrics that can be used in evaluating potential investments and projects.
Here’s a comparison with a few others:
Metric | Focus | Considers Time Value of Money? | Best For |
ARR | Accounting Profitability | No | Simple, quick evaluations |
NPV | Net Cash Flows | Yes | Long-term, large investments |
IRR | Rate of Return | Yes | Evaluating project profitability |
Payback Period | Time to Recoup Investment | No | Liquidity-focused projects |