Accounting Rate of Return (ARR)

What is ARR?

The Accounting Rate of Return (ARR) is a capital budgeting metric that measures an investment’s profitability as an annual percentage of the initial investment. It uses accounting profit (after expenses and depreciation) rather than cash flows to evaluate projects and compare potential investments.

How to calculate ARR

ARR is calculated as:

ARR = (Average Annual Profit / Initial Investment) × 100%

Steps:
* Estimate annual revenues and subtract annual operating expenses to get annual profit.
* If the investment is a fixed asset, subtract annual depreciation to obtain accounting profit.
* Compute the average annual profit over the project life.
* Divide the average annual profit by the initial investment and convert to a percentage.

Worked example

A project requires an initial investment of $250,000 and is expected to generate $70,000 of accounting profit each year for five years.

ARR = $70,000 / $250,000 = 0.28 → 28%

Advantages

• Simple to calculate and easy to understand.
• Useful for quick comparisons between projects.
• Provides a straightforward benchmark against a required minimum return.

Limitations

• Ignores the time value of money—future profits are treated the same as current profits.
• Based on accounting profit rather than cash flows; noncash items (like depreciation) can distort results.
• Does not account for the timing or risk of cash flows, making it less reliable for long-term or uneven-payoff projects.

ARR versus Required Rate of Return (RRR)

• ARR is a computed rate of return for a specific project based on accounting profits.
• RRR (or hurdle rate) is the minimum return an investor or firm requires to accept a project, reflecting risk and opportunity cost.
• Decision rule: accept projects whose ARR meets or exceeds the RRR; when comparing projects, prefer the one with the higher ARR (provided it also meets the RRR).

ARR versus Internal Rate of Return (IRR)

• IRR is a discounted cash flow (DCF) metric that finds the discount rate making the net present value of cash flows zero; it accounts for the time value of money and cash-flow timing.
• ARR does not discount cash flows and uses accounting profit, not cash flow. IRR is generally more appropriate when cash flow timing and present value matter.

How depreciation affects ARR

Depreciation reduces accounting profit and therefore lowers ARR. Because ARR relies on accounting profit, noncash charges like depreciation directly influence the result.

Decision rules and practical use

• Use ARR for simple, early-stage screening or when accounting profit comparisons are required.
• Prefer DCF methods (NPV, IRR) when timing of cash flows and the time value of money are important.
• When choosing among mutually exclusive projects, accept the one with the highest ARR only if it meets or exceeds the company’s RRR and other qualitative criteria.

When to use ARR

• Quick comparisons between similar projects with comparable life spans.
• Situations where accounting measures are required for internal reporting or performance evaluation.
• Not recommended as the sole metric for long-term capital budgeting decisions.

Summary

ARR is a straightforward profitability measure that expresses average annual accounting profit as a percentage of the initial investment. Its simplicity makes it useful for initial screening and comparisons, but its failure to consider cash-flow timing and the time value of money limits its reliability for final investment decisions. Use ARR alongside DCF methods and risk assessments for a balanced evaluation.