In project management, the accounting rate of return (ARR) is a crucial metric used to assess the financial viability and profitability of an investment or project. It measures the average annual return on investment, considering the initial investment cost and the net income generated over the project’s lifespan. By utilizing ARR, project managers and decision-makers can evaluate the potential profitability of various projects and make informed decisions about resource allocation and project selection.
Key Facts
- Definition: The accounting rate of return (ARR) is calculated as the average annual profit divided by the initial investment.
- Purpose: ARR is commonly used in capital budgeting decisions to assess the expected rate of return from different projects and determine which projects are financially viable.
- Calculation: To calculate ARR, follow these steps:
a. Determine the annual net profit of the investment by subtracting all operating expenses, taxes, and interest associated with the project from the annual revenue.
b. If the investment is a fixed asset, calculate the depreciation expense.
c. Subtract the depreciation expense from the annual net profit to get the true average annual profit.
d. Divide the true average annual profit by the initial cost of the investment and multiply by 100 to get the percentage return. - Example: Suppose a company invests £350,000 in new vehicles, which increase annual revenue by £100,000 and annual expenses by £10,000. The ARR calculation would be as follows:
a. Average annual profit = £100,000 – £10,000 = £90,000
b. Depreciation expense = £350,000 / 20 = £17,500
c. True average annual profit = £90,000 – £17,500 = £72,500
d. ARR = £72,500 / £350,000 = 0.2071 = 20.71%.
Definition of ARR
The accounting rate of return is calculated as the average annual profit divided by the initial investment. It represents the percentage rate of return that an investment is expected to generate over its lifetime. ARR is expressed as a percentage and is commonly used in capital budgeting decisions to assess the expected rate of return from different projects and determine which projects are financially viable.
Purpose of ARR
The primary purpose of ARR is to provide a standardized method for comparing the profitability of different investment opportunities. By calculating the ARR for each project, project managers and decision-makers can rank the projects based on their expected returns and make informed decisions about which projects to pursue. Additionally, ARR can be used to evaluate the performance of ongoing projects and determine whether they are meeting their financial targets.
Calculating ARR
To calculate ARR, the following steps are typically followed:
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Determine the annual net profit of the investment
This involves subtracting all operating expenses, taxes, and interest associated with the project from the annual revenue.
-
Calculate the depreciation expense
If the investment is a fixed asset, such as property or equipment, the depreciation expense needs to be calculated. Depreciation is the process of allocating the cost of the asset over its useful life.
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Subtract the depreciation expense from the annual net profit
This step provides the true average annual profit, which is the profit generated by the investment after accounting for depreciation.
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Divide the true average annual profit by the initial cost of the investment
This calculation results in a decimal value, which is then multiplied by 100 to obtain the percentage return, representing the ARR.
Example of ARR Calculation
Consider a company that invests £350,000 in new vehicles, which increase annual revenue by £100,000 and annual expenses by £10,000. The ARR calculation would be as follows:
-
Average annual profit
£100,000 – £10,000 = £90,000
-
Depreciation expense
£350,000 / 20 = £17,500
-
True average annual profit
£90,000 – £17,500 = £72,500
-
ARR
£72,500 / £350,000 = 0.2071 = 20.71%
Therefore, the ARR for this investment is 20.71%, indicating that for every £1 invested, the company can expect a return of 20.71p.
Limitations of ARR
While ARR is a useful tool for evaluating investment opportunities, it has certain limitations that project managers and decision-makers should be aware of:
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Does not consider the time value of money
ARR assumes that all cash flows are of equal value, regardless of when they occur. This can lead to inaccurate results, especially for projects with uneven cash flows over time.
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Ignores the impact of inflation
ARR does not take into account the effects of inflation, which can erode the value of future cash flows. This can result in an overestimation of the actual return on investment.
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Does not consider risk
ARR does not incorporate any measure of risk, which is a crucial factor in investment decisions. Projects with higher risk should generally offer higher returns to compensate for the increased uncertainty.
Conclusion
The accounting rate of return (ARR) is a valuable tool for project managers and decision-makers to assess the financial viability and profitability of investment opportunities. By calculating the ARR for various projects, they can compare the expected returns and make informed decisions about resource allocation and project selection. However, it is important to be aware of the limitations of ARR and consider other factors such as the time value of money, inflation, and risk when making investment decisions.
References
- Investopedia: Accounting Rate of Return (ARR): Definition, How to Calculate, and Example (https://www.investopedia.com/terms/a/arr.asp)
- GoCardless: Accounting Rate of Return (ARR) Calculation | GoCardless (https://gocardless.com/en-us/guides/posts/calculating-accounting-rate-of-return/)
- SmartAsset: Understanding Accounting Rate of Return (ARR) (https://smartasset.com/financial-advisor/accounting-rate-of-return)
FAQs
What is the definition of ARR in project management?
The accounting rate of return (ARR) is a financial metric used in project management to measure the average annual return on investment. It is calculated by dividing the average annual profit by the initial investment cost and is expressed as a percentage.
What is the purpose of calculating ARR in project management?
ARR is primarily used to compare the profitability of different investment opportunities and make informed decisions about resource allocation and project selection. It allows project managers and decision-makers to rank projects based on their expected returns and choose the ones with the highest potential for financial gain.
How is ARR calculated in project management?
To calculate ARR, the following steps are typically followed:
- Determine the annual net profit of the investment
- Calculate the depreciation expense (if the investment is a fixed asset)
- Subtract the depreciation expense from the annual net profit to get the true average annual profit
- Divide the true average annual profit by the initial cost of the investment
- Multiply the result by 100 to obtain the percentage return (ARR)
What are the limitations of using ARR in project management?
ARR has certain limitations, including:
- It does not consider the time value of money, assuming all cash flows are of equal value regardless of when they occur.
- It ignores the impact of inflation, which can erode the value of future cash flows.
- It does not incorporate any measure of risk, which is a crucial factor in investment decisions.
How can ARR be used effectively in project management?
ARR can be used effectively in project management by:
- Comparing the ARR of different projects to identify the ones with the highest potential for financial return.
- Evaluating the ARR of ongoing projects to assess their performance and determine if they are meeting their financial targets.
- Making informed decisions about resource allocation and project selection based on the ARR of each project.
Are there any alternatives to ARR in project management?
Yes, there are other financial metrics that can be used in project management, such as:
- Net present value (NPV)
- Internal rate of return (IRR)
- Payback period
- Profitability index
Which financial metric is better, ARR or NPV?
ARR and NPV are both useful financial metrics, but they have different strengths and weaknesses. ARR is simpler to calculate and understand, while NPV considers the time value of money and is generally considered a more comprehensive measure of profitability.
How can project managers use ARR to make better decisions?
Project managers can use ARR to make better decisions by:
- Using ARR as a screening tool to identify projects with the highest potential for financial return.
- Considering ARR in conjunction with other financial metrics, such as NPV and IRR, to get a more comprehensive view of a project’s profitability.
- Evaluating the ARR of ongoing projects to make informed decisions about resource allocation and project continuation.