Management Accounting · Asset budgeting and investment appraisal

Accounting Rate of Return (ARR): Formula and Average Investment

Updated 11 October 2026 · Fact-checked

Accounting rate of return (ARR) measures the average yearly accounting profit as a percentage of the investment. Use ARR = average annual profit ÷ investment × 100. The investment is either the initial cost or the average investment, (initial cost + residual value) ÷ 2. Always use the basis the question states.

Understand Accounting Rate of Return (ARR)

Accounting rate of return, or ARR, is an investment appraisal method. It asks a simple question: how much profit does a project earn each year, compared with the money tied up in it?

ARR uses accounting profit, not cash flow. Profit is after depreciation. So you must deduct depreciation from the cash inflows before you find the average profit. This is the point where most marks are lost.

The average annual profit is total profit over the project life divided by the number of years. The investment can be measured in two ways. The initial investment basis uses the original cost. The average investment basis uses (initial cost + residual value) ÷ 2. This reflects that the asset's book value falls over time.

ARR is then compared with a target return set by the business. If ARR is higher than the target, the project is acceptable. If you compare two projects, the higher ARR is preferred.

ARR is easy to calculate and uses figures from the accounts. But it ignores the time value of money, uses profit not cash, and gives different answers depending on the basis used. Percentage results also ignore project size. It is related to ROCE, which measures a whole business's return, while ARR looks forward at one project.

Key formulas to remember

ARR (initial investment basis): ARR = average annual accounting profit ÷ initial investment × 100%; Use when the question says initial investment or gives no other instruction and the syllabus basis is clear.
ARR (average investment basis): ARR = average annual accounting profit ÷ average investment × 100%; Use when the question asks for average investment.
Average investment: Average investment = (initial cost + residual value) ÷ 2; If residual value is nil, this is half of the initial cost.
Average annual profit: Average annual profit = (total cash inflows − total depreciation − other non-cash items) ÷ number of years; Total depreciation = initial cost − residual value. Equivalent to total profit ÷ years.
Annual depreciation (straight line): (cost − residual value) ÷ useful life; Needed to turn cash flows into profits.
Decision rule: Accept if ARR ≥ target return; with alternatives, choose the highest ARR; Only valid if all figures use the same basis.

How to solve Accounting Rate of Return (ARR) questions

Follow the same order every time. The method works for single projects and for comparing projects.

1Read which investment basis is required: initial or average. Note the target ARR if one is given.
2Find the total profit over the project life. Start with total cash inflows (net of operating cash costs) and deduct total depreciation.
3Calculate total depreciation as initial cost minus residual value. Do not deduct the residual value twice.
4Divide total profit by the number of years to get the average annual profit.
5Work out the investment figure: the initial cost, or (initial cost + residual value) ÷ 2.
6Divide average profit by the investment and multiply by 100.
7Compare with the target return and state accept or reject. Round only at the end.
8For multiple response questions, check each statement against the method before choosing.

Quickest way: Total profit shortcut

When to use it: Use this for number entry or multiple choice questions where each year's profit is not needed.

Add all cash inflows and subtract all cash costs to get total net cash flow.
Subtract (cost − residual value) once. This gives total profit.
Divide by the number of years.
Divide by cost for the initial basis, or by (cost + residual) ÷ 2 for the average basis.
Convert to a percentage and check it against the answer options for sense.

Common mistakes in Accounting Rate of Return (ARR)

Using cash flow instead of profit
Students learn NPV and payback first, which use cash flows, and carry the habit across.
Fix: Always deduct depreciation from cash inflows before averaging. ARR is an accounting measure.
Deducting depreciation using the full cost
Students forget the residual value when the asset is sold at the end.
Fix: Depreciation is cost minus residual value. Write it down before you start.
Using the wrong average investment
Students divide cost by 2 and ignore the residual value, or add instead of averaging.
Fix: Use (cost + residual value) ÷ 2. Check that the result lies between cost and residual value.
Dividing by the wrong number of years
Students count time 0 as a year or miss the final year.
Fix: Count the years of operation only. A project with inflows in years 1 to 4 has four years.
Mixing bases when comparing projects
One project is calculated on initial cost and another on average cost under time pressure.
Fix: Use one basis for every project in the comparison.
Confusing ARR with ROCE
Both are percentage returns based on profit and capital.
Fix: ARR appraises a future project using average profit. ROCE measures past performance of a business using profit before interest and tax ÷ capital employed.

Worked examples

Example 1

A project costs $120,000 and has a residual value of $20,000 after four years. Net cash inflows are $40,000, $50,000, $45,000 and $35,000 in years 1 to 4. Calculate the ARR based on average investment.

Show the solution

Total cash inflows = 40,000 + 50,000 + 45,000 + 35,000 = $170,000.
Total depreciation = 120,000 − 20,000 = $100,000.
Total profit = 170,000 − 100,000 = $70,000.
Average annual profit = 70,000 ÷ 4 = $17,500.
Average investment = (120,000 + 20,000) ÷ 2 = $70,000.
ARR = 17,500 ÷ 70,000 × 100 = 25%.

Answer: ARR = 25%

Example 2

A company buys a machine for $80,000 with no residual value. It will last five years and generate total net cash inflows of $140,000. The target ARR on initial investment is 15%. Should the company accept the project?

Show the solution

Total depreciation = 80,000 − 0 = $80,000.
Total profit = 140,000 − 80,000 = $60,000.
Average annual profit = 60,000 ÷ 5 = $12,000.
ARR on initial investment = 12,000 ÷ 80,000 × 100 = 15%.
The ARR equals the target of 15%.

Answer: ARR is 15%, which meets the target, so the project is acceptable (on the rule ARR ≥ target).

Exam tips

Read the question for the word initial or average before you calculate. The basis changes the answer.
Check whether the figures given are cash flows or profits. If cash flows, deduct depreciation. If profits, do not deduct again.
In number entry questions, give the percentage to the decimal places requested and do not round early.
For multiple response questions on advantages and disadvantages, remember: ARR is simple and uses accounting profit, but ignores the time value of money and cash flow timing.
If the question asks about ROCE versus ARR, link ARR to project appraisal and ROCE to whole-business performance.

Practice questions from Asset budgeting and investment appraisal

Accounting Rate of Return (ARR) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Accounting Rate of Return (ARR): frequently asked questions

What is the ARR formula in ACCA MA?

ARR = average annual accounting profit ÷ investment × 100. The investment is either the initial cost or the average investment, (cost + residual value) ÷ 2. Use whichever the question states.

How do I calculate ARR using average investment?

First find average annual profit after depreciation. Then calculate average investment as (initial cost + residual value) ÷ 2. Divide profit by that figure and multiply by 100.

What is the difference between ARR and ROCE?

ARR is used to appraise a proposed project using forecast average profit. ROCE is a ratio of profit before interest and tax to capital employed, used to measure how well a business has performed. The calculations look similar, but the purpose differs.

Does ARR use cash flows?

No. ARR uses accounting profit, so depreciation must be deducted from cash inflows. This is why it differs from NPV, IRR and payback, which all use cash flows.