Accounting Rate of Return

Accounting rate of return, sometimes abbreviated ARR, is an indicator of profitability calculated by dividing the average accounting net income an investment is expected to generate by the amount originally invested in it. It gives a simple, single percentage that managers can use to screen or compare competing capital projects without building a full discounted cash flow model.

The formula takes the average annual net income a project is projected to produce over its life and divides it by either the initial investment or the average investment (often calculated as the midpoint between the initial cost and expected salvage value). A project expected to cost $1,000,000 and generate average annual accounting profit of $150,000 has an accounting rate of return of 15%, a figure management can then compare against a minimum acceptable rate, or hurdle rate, before deciding whether to proceed.

Unlike net present value or internal rate of return, accounting rate of return is based on accrual accounting profit, which includes non-cash charges such as depreciation, rather than on the project's actual cash flows. It also ignores the time value of money entirely, treating a dollar of profit earned in year one exactly the same as a dollar earned in year ten, which is a significant theoretical weakness compared with discounted cash flow techniques that explicitly account for when money actually arrives.

Despite its theoretical shortcomings, accounting rate of return remains popular in practice because it is quick to calculate from numbers management already has at hand, it produces a result expressed in the same accounting-profit terms used throughout the rest of the business's reporting, and it is easy to explain to non-financial managers who may find discounted cash flow concepts harder to follow. It is also sometimes required internally because compensation or performance evaluation is itself based on accounting profit rather than cash flow, making ARR a more directly relevant measure for managers whose bonuses depend on reported earnings.

Because accounting rate of return ignores the timing of cash flows, it can rank two projects as equally attractive even when one delivers most of its profit early and the other delivers it mostly near the end, a difference that genuinely matters once the time value of money is considered. For this reason, most finance textbooks and corporate capital budgeting policies recommend using accounting rate of return only as a quick, supplementary screen, alongside — never instead of — a proper discounted cash flow analysis for any significant investment decision. Smaller businesses and departments without easy access to discounted cash flow modeling nonetheless rely on it heavily in practice, precisely because it can be calculated directly from an ordinary budget or forecast without any specialized financial training.

Consider two $500,000 projects, each expected to run five years. Project A generates $100,000 of accounting profit in year one, declining to $60,000 by year five; Project B generates the reverse pattern, starting at $60,000 and rising to $100,000. Both produce an identical average annual profit of $80,000 and therefore an identical 16% accounting rate of return — yet Project A, which delivers its profit earlier, is clearly more valuable once the time value of money is taken into account, a distinction accounting rate of return is simply unable to make on its own.