Business Management - Making Financial Decisions - Accounting rate of return

Accounting rate of return

Initial method

Formula: Average annual accounting profit/Initial amount of the investment to earn that profit x 100%

Method:

• Add up all cash flows plus scrap
• Minus initial investment, leaving total profits 
• Divide total profits by number of years used, leaving average annual profit
• Divide average annual profit by initial investment

Average method

Formula: Average annual accounting profit/Average amount of the investment (at the mid-point) to earn that profit*

Average investment = Initial investment + Scrap value/2

Method:

• Add the initial investment to the scrap value, leaving a subtotal
• Divide the subtotal by 2, leaving money in 
• Divide average annual profit by money in

Advantages

• Simple to understand. Uses a percentage which managers may be more comfortable with. This also makes it more objective for managers.
• Shareholders often use a company's overall ARR, i.e. using total profit, as a means of evaluating the business, and thus managerial performance. This is used to maximise profits within the business and allows an assessment of the business.
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