How to Calculate the Accounting Rate of Return
The simplest rate of return to calculate is the accounting rate of return (ARR). This is a very fundamental calculation to determine how much value an investment generates for the corporation and its owners, the stockholders. It requires only two pieces of information: the amount of earnings before interest and taxes (EBIT) generated by the project and the cost of the investment.
Once you know those two things, the calculation goes like this:
ARR = EBIT attributed to project / Net investment
The accounting rate of return is calculated by dividing the amount of EBIT generated by the project by the net investment of the project. This calculation tells you the proportion of net earnings before taxes that you’re generating for the investment cost.
This calculation is usually done on a year-by-year basis. Note that because this equation doesn’t take multi-period variables into consideration, you have to calculate it anew for each period (usually a year). So, in year 1, you might calculate a –3 percent rate of return.
That sounds bad, but if you’re talking about the investment on developing a whole new product line, you need to consider that sales are usually slow during the first year. By year 3, you might expect a 2 percent rate of return, and so forth.
You may be asking how to determine the amount of EBIT to attribute to a given project! The answer isn’t too bad. Basically, you just go through the steps of developing an income statement, but only for the new project. Find out how many sales this new line or product is generating, and then subtract the costs of operating the project. That’s simple, right?
When your capital investment is just a single step in the production process, determining how much value is being added by that step takes a little more work. Basically, you have to break down the entire production process into its individual contributing steps. The total production process is 100 percent of the final product.
There are a couple ways to determine what percentage of the production process a single step constitutes. One way is to simply use a proportion of the total cost of production. Sure, this method is easy, but there’s a better way:
You can do something called transfer pricing, which estimates the market value of each step in the process by doing some research to find out how much it would cost to hire some other company to do that step. This method helps you in two ways:
It helps you do your capital budgeting by determining the amount of added value for that single step and the amount of EBIT you can attribute to that step, to make sure that the investment will actually generate a positive return on investment.
It determines the fair market value of performing that step to see whether your company is being financially efficient. If some other company can perform that step better or more cheaply, you should probably outsource that step to the other company.
If you know the lifespan of the project or machine, you can forecast the rate of return you experience each year. Whether you’re successful at this forecast or not will depend entirely on how closely your forecasts match the actual rate of returns, of course, but you can still do these forecasts.
The total rate of return on the investment is the total EBIT generated by that investment divided by the cost of the investment. The revenues used to calculate EBIT include all the revenues that investment generates over its entire life, plus the final revenue generated using its salvage or scrap value. The final revenue generated by any project is its scrap or salvage value.