Accounting Rate of Return (ARR): A Guide to a Simple Capital Budgeting Tool

At its core, the Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a capital budgeting metric used to evaluate the profitability of a proposed investment. It is a percentage that expresses the average annual profit a project is expected to generate, relative to the initial or average investment cost.

Unlike other capital budgeting techniques that focus on a project’s cash flows, ARR is unique because it relies on accounting profits—specifically, a project’s net income after taxes and depreciation. This makes it a great “first-look” tool because the data needed for the calculation is readily available from a company’s financial statements.

The formula for the Accounting Rate of Return is deceptively simple:

ARR = Average Annual Net Income​ / Initial Investment or Average Investment

Let’s break down the two key components of this formula.

Average Annual Net Income

This is not the total profit over the project’s life, but the average annual profit. You calculate this by summing up all the projected net income figures for each year of the project and then dividing that total by the number of years. Remember, this figure is after subtracting all expenses, including non-cash items like depreciation.

Initial Investment or Average Investment

The denominator can be either the initial cost of the project or the average book value of the investment over its life. The “average investment” method is often preferred because it accounts for the asset’s depreciating value over time. To calculate the average investment, you take the initial cost plus the salvage value (if any) and divide by two.

To truly understand ARR, let’s walk through a practical example. Imagine a company, “Innovate Inc.,” is considering a project that requires an initial investment of $200,000. The project is expected to last for five years and generate the following annual net incomes:

• Year 1: $30,000
• Year 2: $40,000
• Year 3: $50,000
• Year 4: $60,000
• Year 5: $20,000

The equipment used in the project has no salvage value at the end of the five years.

First, let’s calculate the average annual net income: 

Total Net Income = $30,000 + $40,000 + $50,000 + $60,000 + $20,000 = $200,000 

Average Annual Net Income = $200,000 / 5 years = $40,000

Next, we’ll use the initial investment as our denominator. Initial Investment = $200,000

Now, we can calculate the ARR: ARR = $40,000 / $200,000 = 0.20 or 20%

This means the project is expected to return an average of 20% on the initial investment each year.

So, what do you do with that 20%? You compare it to a predetermined hurdle rate or required rate of return. This is the minimum percentage return a company demands from its projects. 

If the project’s ARR is greater than or equal to the hurdle rate, it’s considered a potentially viable investment. If it’s lower, the project is rejected. For example, if Innovate Inc.’s hurdle rate is 15%, the project with a 20% ARR would be accepted. If their hurdle rate was 25%, it would be rejected.

Like any financial tool, the Accounting Rate of Return has its strengths and weaknesses. It’s crucial to understand these to use it effectively and avoid making poor investment decisions.

ARR is popular for a reason—its simplicity.

• Easy to Calculate and Understand: The ARR formula is straightforward, making it accessible to a wide range of business professionals, not just finance experts. It uses data that’s already compiled in a company’s financial statements, reducing the need for new, complex projections.
• Aligns with Accounting Metrics: Since ARR is based on accounting profits, it aligns well with a company’s overall profitability goals. A project with a high ARR contributes directly to the company’s net income, a key metric tracked by investors and management.
• Considers the Entire Project Life: Unlike the payback period method, which only measures how long it takes to recoup the initial investment, ARR considers the profitability of the project over its entire lifespan.

Despite its simplicity, ARR has some significant flaws that must be carefully considered.

• Ignores the Time Value of Money: This is perhaps the biggest weakness of the ARR method. It treats a dollar of profit earned today the same as a dollar earned five years from now. In reality, a dollar today is worth more due to inflation and the opportunity to invest it. This flaw can lead to misleading comparisons between projects, especially those with different timelines for their returns.
• Based on Accounting Profit, Not Cash Flow: ARR uses net income, which includes non-cash items like depreciation. However, the true measure of a project’s value and a company’s solvency is its cash flow. A project might show a high ARR on paper but still cause cash flow problems if its profits are tied up in accounts receivable.
• Lack of a Clear Hurdle Rate: The required rate of return or hurdle rate is often an arbitrary number set by management. What is a “good” return? 10%? 20%? Without a clear, universally accepted benchmark, the decision-making process can be subjective and inconsistent.

Given its limitations, especially its failure to account for the time value of money, you might wonder why ARR is still taught and used. The key is to view it not as a standalone solution, but as a supplementary tool in your financial arsenal.

Think of ARR as a quick, back-of-the-envelope calculation. When a company is presented with dozens of potential projects, ARR can be a great first filter. It can quickly weed out projects that clearly don’t meet a basic profitability threshold before more time-consuming analyses, like Net Present Value (NPV) or Internal Rate of Return (IRR), are performed.

A strong investment strategy never relies on a single metric. By combining the simplicity and profitability focus of ARR with the more sophisticated, time-sensitive insights from NPV and IRR, you can build a more robust and reliable picture of a project’s true value. ARR gives you the “what,” while other tools provide the “when” and “how much.”

In conclusion, the Accounting Rate of Return is a foundational concept in capital budgeting. It provides a simple, percentage-based measure of a project’s profitability that is easy to calculate and understand. While its simplicity is its greatest strength, it is also the source of its most significant weaknesses, namely its disregard for the time value of money and its reliance on accounting profits over actual cash flows.

For investors and business owners with some baseline financial knowledge, ARR serves as an excellent starting point for evaluating potential projects. However, a truly informed decision requires a holistic approach. By using ARR as an initial screening tool and then moving on to more sophisticated methods for the most promising projects, you can leverage the best of both worlds—the speed of a simple calculation and the accuracy of a detailed financial model.

Ready to put this knowledge into practice? Try calculating the ARR for a hypothetical investment of your own. What minimum return would you require before accepting a project? Understanding this benchmark is the first step toward becoming a more confident and strategic investor.