How to Calculate Accounting Rate of Return?

The accounting rate of return (ARR) measures the average annual accounting profit an investment is expected to generate as a percentage of the money invested.

To calculate it, divide the project’s average annual accounting profit by either its initial investment or average investment, depending on the method used by the business, and multiply the result by 100.

ARR is useful when a startup or established business needs a quick way to compare equipment, technology, premises or expansion projects. However, the calculation must use accounting profit rather than cash flow, and every project being compared must follow the same formula.

What Is the Accounting Rate of Return?

The accounting rate of return is a capital budgeting measure that estimates the profitability of an investment. It is also sometimes called the average rate of return.

For example, an ARR of 15% means the project is expected to generate average annual accounting profit equal to 15% of the investment figure used in the calculation. It does not mean the business will receive a 15% cash payment each year.

ARR is based on figures reported in the accounts, including depreciation. Reliable forecasts therefore depend on accurate financial records.

A consistent approach to bookkeeping for small businesses makes it easier to separate revenue, operating costs, asset values and depreciation before assessing an investment.

What Is the Formula for Accounting Rate of Return?

Two versions of the ARR formula are widely used.

Initial investment method:

ARR = (Average annual accounting profit ÷ Initial investment) × 100

Average investment method:

ARR = (Average annual accounting profit ÷ Average investment) × 100

Where straight-line depreciation is used, average investment is commonly calculated as:

Average investment = (Initial investment + Residual value) ÷ 2

The average investment method usually produces a higher ARR because the denominator reflects the asset’s declining book value. Neither method should be selected simply because it gives a more attractive result.

The business should use the formula required by its finance policy, lender, investor or assessment framework and state the method clearly.

Which Figures Are Needed to Calculate ARR?

An ARR calculation normally requires the initial investment, expected useful life, residual value and forecast accounting profit for each year.

The figures should come from one consistent set of assumptions. Mixing optimistic sales forecasts with conservative cost estimates can make an unattractive investment appear profitable.

How Do You Calculate ARR Step by Step?

1. Establish the Initial Investment

Start with the full cost needed to make the project operational. For a machine, this might include its purchase price, delivery, installation and testing. For a software project, it could include implementation, data migration, training and other directly attributable setup costs.

If the business includes working capital in its investment base, that treatment should be applied consistently to every option. Do not include routine financing costs in one project but exclude them from another.

2. Calculate Annual Depreciation

ARR uses accounting profit, so depreciation must be recognised. Under straight-line depreciation:

Annual depreciation = (Initial cost − Residual value) ÷ Useful life

If an asset costs £120,000, is expected to be worth £20,000 after five years and is depreciated on a straight-line basis, the annual depreciation charge is:

(£120,000 − £20,000) ÷ 5 = £20,000

The depreciation method used in the ARR forecast should match the business’s accounting policy where practical.

3. Estimate the Accounting Profit for Each Year

Calculate the forecast profit attributable to the investment for every year:

Accounting profit = Project revenue or savings − Operating costs − Depreciation − Tax, if applicable

ARR should not be calculated from cash inflows alone. Depreciation is not a cash payment, but it reduces accounting profit and is therefore relevant to the measure.

4. Find the Average Annual Accounting Profit

Add the forecast accounting profits for all years and divide the total by the project’s useful life:

Average annual accounting profit = Total accounting profit over the project life ÷ Number of years

If the forecast profits over five years are £12,000, £16,000, £19,000, £17,000 and £14,000, the total profit is £78,000. The average is:

£78,000 ÷ 5 = £15,600

5. Apply the Chosen ARR Formula

Using the initial investment method:

ARR = (£15,600 ÷ £120,000) × 100 = 13%

Using the average investment method, first calculate the denominator:

Average investment = (£120,000 + £20,000) ÷ 2 = £70,000

The ARR is then:

ARR = (£15,600 ÷ £70,000) × 100 = 22.29%

The same project therefore has an ARR of 13% under the initial investment method and approximately 22.3% under the average investment method. This is why an ARR percentage is meaningful only when the formula and assumptions are disclosed.

How Should a Business Interpret the ARR Result?

A business can compare the calculated ARR with its minimum acceptable accounting rate of return, sometimes called a hurdle rate.

If the required ARR is 12% and the company uses the initial investment method, the example project’s 13% ARR passes the initial test. If its required ARR is 15%, it fails.

When comparing several investments, a higher ARR indicates greater forecast accounting profitability, provided that all options use the same denominator, depreciation policy, tax basis and forecast period.

The result should then be reviewed alongside affordability, risk, cash requirements and strategic value.

Businesses can incorporate actual results into regular management accounts after approval. Comparing forecast ARR assumptions with real revenue, costs and profit can reveal whether the investment is performing as expected.

What Is a Good Accounting Rate of Return?

There is no universal percentage that makes an ARR good or bad. An acceptable rate depends on the company’s objectives, industry, cost structure, risk appetite and alternative uses for its money.

A business might establish its minimum ARR by considering:

• the returns normally produced by existing operations;
• the risk and uncertainty attached to the project;
• the return available from competing investment options; and
• the minimum return expected by owners or senior management.

A project should not automatically be approved because its ARR is positive. It must exceed the relevant internal target and remain viable if revenue is lower or costs are higher than forecast.

How Can ARR Be Used to Compare Two Projects?

Suppose a business is considering two pieces of equipment and uses initial cost as the investment base.

Project A has the higher ARR, even though Project B produces more profit in pounds. This shows that ARR measures profit relative to investment rather than total profit alone.

However, Project B could still be preferable if it has a longer useful life, lower operational risk, stronger cash flows or greater strategic importance. The percentage helps frame the decision; it does not make the whole decision.

What Mistakes Can Make an ARR Calculation Inaccurate?

The most common error is using average annual cash flow instead of average annual accounting profit. Cash flow and profit are different measures, particularly where depreciation, credit sales or unpaid costs are involved.

Other errors include forgetting residual value, omitting installation costs, using total lifetime profit rather than average annual profit and comparing projects calculated under different ARR formulas.

Mixing pre-tax profit for one option with post-tax profit for another also creates a misleading result.

Forecast quality matters just as much as the equation. Sales volumes, selling prices, maintenance costs, staffing requirements and asset life should be supported by reasonable evidence. Scenario testing can show what happens to ARR if trading is weaker than expected.

Free accounting software for small businesses may help organise actual income and expense information, but spreadsheet or software output is only as reliable as the assumptions entered.

What Are the Advantages of Accounting Rate of Return?

ARR is relatively simple to calculate and explain. It expresses expected profitability as a percentage, making it convenient for initial comparisons and management discussions.

It also uses accounting profit, a measure that owners and managers already see in budgets and financial reports. Unlike the payback period, ARR considers profit across the investment’s full forecast life rather than stopping when the original cost has been recovered.

What Are the Limitations of Accounting Rate of Return?

ARR does not account for the time value of money. A £20,000 profit expected in year one is treated in the same way as £20,000 expected in year five, even though earlier returns are normally more valuable and less uncertain.

It also focuses on accounting profit rather than cash generation. A project may show a healthy ARR while putting pressure on cash flow because customers pay slowly or substantial expenditure occurs early.

The result is sensitive to accounting policies and estimates, especially useful life, depreciation, residual value and cost allocation. Different denominator conventions can also create materially different percentages, as the worked example demonstrates.

For these reasons, ARR is best used as a screening tool rather than the only basis for approving a major investment.

How Does ARR Compare With Other Investment Measures?

For a material or long-term commitment, businesses should normally consider cash-flow forecasts, payback and a discounted cash-flow method alongside ARR. Qualitative factors such as regulatory requirements, product quality, staff safety and customer experience may also affect the final decision.

How Can a Business Make a Better ARR Decision?

Begin with a base-case forecast, then recalculate the ARR under realistic downside and upside scenarios. For example, test the effect of a 10% reduction in sales, a delay in launch, higher maintenance costs or a lower residual value.

The decision paper should record the formula used, whether profit is before or after tax, how depreciation was calculated and which costs are included in the investment base. This creates a clear comparison and prevents the percentage from being presented without context.

After the investment begins, compare actual performance with the original assumptions. If revenue, costs or asset life change materially, an updated calculation can support decisions about corrective action, further investment or disposal.

Conclusion

To calculate accounting rate of return, find the project’s average annual accounting profit, divide it by the selected investment base and multiply by 100. The calculation is straightforward, but the result depends heavily on the denominator, depreciation method and forecast assumptions used.

ARR can help a business screen and compare investments, particularly when accounting profitability is important. For a sound decision, the company should state its method clearly, apply it consistently and assess cash flow, timing and risk alongside the final percentage.

Frequently Asked Questions

Is ARR Based on Profit or Cash Flow?

ARR is based on accounting profit, not cash flow. The profit figure normally includes depreciation and should follow a consistent pre-tax or post-tax basis.

Does ARR Include Depreciation?

Yes. Depreciation reduces the accounting profit used in the numerator. Omitting it would turn the calculation into a different form of return based more closely on cash flow.

Should ARR Use Initial Investment or Average Investment?

Both conventions are used. A business must follow its chosen policy and state the denominator clearly. Projects should only be compared when the same method has been applied to each one.

Can Accounting Rate of Return Be Negative?

Yes. If the project is expected to make an average annual accounting loss, its ARR will be negative. This usually indicates that it does not meet a profitability-based investment test, although a compulsory or strategically essential project may still be considered for other reasons.

Is a Higher ARR Always Better?

A higher ARR indicates stronger forecast accounting profitability under the assumptions used, but it does not automatically make one project better. Cash timing, project scale, useful life, risk and strategic value must also be considered.