Next we need to convert this profit for the whole project into an average figure, so dividing by five years gives us $8,000 ($40,000/5).

*Calculating the denominator*

Now we have the numerator, we need to consider the denominator, i.e. the investment figure.

The investment figure can either be

- the initial investment, or
- the average investment, where the average investment is calculated:

(the initial investment + scrap value)/2

So in this case:

- the initial investment is $40,000
- the average investment is ($40,000 + $5,000)/2 = $22,500

*Calculating the accounting rate of return*

The accounting rate of return can now be calculated as either:

- ($8,000/$40,000) x 100% = 20% or
- ($8,000/$22,500) x 100% = 36%

This approach should be used for any accounting rate of return calculation, no matter how easy or difficult:

*Calculate the numerator:*

- Calculate the profit for the whole project. Include not only cash revenue and cash costs, but also other costs such as depreciation, amortisation etc.
- Calculate the average annual profit, by dividing the profit over the whole project by the life of the project.

Calculate the denominator

Look in the question to see which definition of investment is to be used. If the question does not give the information, then use the average investment method, and state this in your answer.

*Calculate the accounting rate of return.*

Show your answer as a percentage.

__Usefulness__

Having calculated the percentage answer, how can this be used for project appraisal?

The accounting rate of return percentage needs to be compared to a target set by the organisation. If the accounting rate of return is greater than the target, then accept the project, if it is less then reject the project.

This leads to a couple of problems:

- How is the target set? Should it be 25%, or 30%? The target set could be arbitrary
- Which calculation method should be used? If in the above example, the target was 25%, the project would be rejected under one calculation method but accepted under the other, so changing the calculation method can change the decision as to whether the project should be accepted or rejected.

Other problems with the accounting rate of return:

- The timing of the cash flows is not considered. In our example, the biggest cash flow arises in year five, but by then, the organisation may have ceased trading due to liquidity issues in years three and four when only $5,000 cash is being received in each year.
- It is a relative measure rather than an absolute measure – it takes no account of the size of the investment.
- The time value of money is ignored.

There are, however, some positive aspects to the accounting rate of return:

- It is simple to calculate from readily available accounting data – no complicated discount factors to calculate!
- The concept of profit is easily understood by managers, and the answer is easily interpreted – does the project give the necessary accounting return or not?
- The method looks at the whole life of the project, unlike, for example, the payback method which may not.

### Conclusion

Candidates need to be able to calculate the accounting rate of return, and assess its usefulness as an investment appraisal method. It is hoped that this article will help candidates with both of these.

**Written by a member of the FFM examining team**