Using the Accounting Rate of Return Method to Evaluate a Budget

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  • 0:00 Accounting Rate of Return
  • 0:51 Desired ARR
  • 1:28 Calculating ARR
  • 2:07 Making a Decision
  • 2:37 Lesson Summary
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Lesson Transcript
Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After reading this lesson, you'll know the formula you need to calculate the accounting rate of return. You'll also understand how to use the accounting rate of return method in deciding whether a capital budget decision is a good one or a bad one.

Accounting Rate of Return

The accounting rate of return, also called the average rate of return, is the ratio of the average annual accounting profit to the initial investment. It can be used to evaluate a budget, such as a capital budget. A capital budget is a budget for a large project that lasts more than a year.

The formula to calculate the accounting rate of return, or ARR, is:

ARR = (average annual accounting profit) / (initial investment)

This formula specifically helps with capital budget decisions in regards to choosing the right type of investment. ARR is usually expressed as a percentage. ARR is usually used in forecasting calculations so the company can make decisions that will it will benefit from in the future.

Desired ARR

Companies decide on a minimum ARR percentage that a potential investment needs to meet or exceed in order for the company to proceed with the investment. For example, a company that sells baseball bats may want to invest in a new manufacturing machine that will make even more bats in less time than their current manufacturing machine. To help them decide whether or not to invest in this machine, the company decides that any new investments need to meet or exceed an ARR of 10%. This means that this new manufacturing machine must give them a profit of at least 10% of the cost to purchase the manufacturing machine, the initial investment.

Calculating ARR

Let's see how the company calculates the ARR for this manufacturing machine to see if this particular manufacturing machine will meet the company's needs.

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