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Financial Management · Investment appraisal techniques

Accounting Rate of Return (ROCE) in Investment Appraisal

Updated 11 October 2026 · Fact-checked

Accounting rate of return (ARR), also called ROCE, measures average annual accounting profit as a percentage of investment. Use ARR = average annual profit ÷ average investment × 100, or divide by initial investment. Accept the project if ARR is above the target return. It ignores cash flow timing.

Understand Return on Capital Employed (ARR)

Accounting rate of return (ARR) is an investment appraisal method based on accounting profit, not cash flow. It asks one question: what percentage return does the project earn on the money tied up in it?

You start with the profit the project adds each year. This is profit after depreciation. So you take the cash flows and deduct depreciation, or you use the accounting profit given. Then you average that profit over the project life and compare it with the capital invested.

There are two common versions. The first divides by the initial investment. The second divides by the average investment, which is (initial investment + residual value) ÷ 2. The average version is more common in ACCA questions, but always read the question. If it names a method, use it. If not, state which one you chose.

You then compare the ARR with a target return set by the company. If ARR is higher, the project is acceptable on this measure. If you are choosing between projects, the higher ARR looks better.

ARR is easy to understand and links to ROCE, which managers are judged on. But it has real weaknesses. It uses profit, not cash. It ignores the timing of returns and the time value of money. It gives no absolute measure of wealth added. Compared with NPV and IRR, it is a weaker guide to shareholder wealth.

Key rules to remember

ARR using average investment
ARR = average annual accounting profit ÷ average investment × 100%
Average investment = (initial investment + residual value) ÷ 2.
ARR using initial investment
ARR = average annual accounting profit ÷ initial investment × 100%
Gives a lower figure than the average version when there is a residual value less than cost. Use only if the question says so or you state it.
Average annual accounting profit
(total cash inflows − total cash outflows − total depreciation) ÷ number of years
Equivalent to average annual cash flow less average annual depreciation. Depreciation = (cost − residual value) ÷ life for straight-line.
Decision rule
Accept if ARR > target ARR
For mutually exclusive projects, the higher ARR is preferred on this measure alone.

How to solve Return on Capital Employed (ARR) questions

Use the same sequence for any ARR question. It keeps your working clear and earns method marks in written answers.

  1. 1Read which investment base the question requires: initial or average. If it is silent, choose average and say so.
  2. 2List the annual cash flows or accounting profits for each year of the project.
  3. 3If you start from cash flows, calculate annual depreciation = (cost − residual value) ÷ life, and deduct it to get annual accounting profit.
  4. 4Add the annual profits and divide by the number of years to get average annual profit.
  5. 5Calculate the investment base: initial cost, or (initial cost + residual value) ÷ 2.
  6. 6Divide average profit by the base and multiply by 100 to get ARR.
  7. 7Compare ARR with the target return and state accept or reject.
  8. 8If asked to comment, add the key limitations: profit not cash, no time value, percentage not absolute, depends on accounting policies.

Quickest way: Total-profit shortcut

When to use it: Use for objective test questions with straight-line depreciation and a clear initial cost and residual value.

  1. Total profit over the life = total cash inflows − initial cost + residual value if the asset is sold at the end. Equivalently, total cash inflows − total depreciation.
  2. Average profit = total profit ÷ years.
  3. Average investment = (cost + residual value) ÷ 2.
  4. ARR = average profit ÷ average investment. Check the answer is sensible against the options.
  5. Note: do not use this shortcut if the residual value is received as a cash inflow and also included in the cash flow list. Count it once.

Common mistakes in Return on Capital Employed (ARR)

  • Using cash flow instead of accounting profit

    Students are used to NPV, where depreciation is ignored.

    Fix: For ARR always deduct depreciation from the cash flows before averaging. Depreciation is a non-cash item in NPV but part of profit in ARR.

  • Dividing by the wrong investment base

    Questions use 'average' and 'initial' without drawing attention to it.

    Fix: Underline the base in the question. If none is given, use average investment and state that choice.

  • Calculating average investment as cost ÷ 2 when there is a residual value

    Students remember the half but forget the residual value.

    Fix: Use (cost + residual value) ÷ 2. For example, cost ₹10,00,000 and residual value ₹2,00,000 gives ₹6,00,000.

  • Dividing by the wrong number of years

    Students include year 0 in the count.

    Fix: Count only the operating years of the project. Year 0 is the investment date, not a profit-earning year.

  • Double counting working capital or residual value

    Both appear as cash flows in NPV questions.

    Fix: Treat the residual value as the end value of the asset in the depreciation and average calculations. Include working capital in capital employed only if the question tells you to.

  • Saying ARR is better than NPV because it is a percentage

    Percentages seem easier to compare.

    Fix: Explain that ARR ignores timing and cash, and does not measure absolute wealth created. NPV directly shows the change in shareholder wealth.

Worked examples

Example 1

A project costs $400,000 and has a residual value of $40,000 after four years. Annual cash profits before depreciation are $150,000, $160,000, $140,000 and $130,000. Calculate the ARR using average investment.

Show the solution
  1. Annual depreciation = (400,000 − 40,000) ÷ 4 = $90,000.
  2. Total cash profits = 150,000 + 160,000 + 140,000 + 130,000 = $580,000.
  3. Total depreciation = 90,000 × 4 = $360,000.
  4. Total accounting profit = 580,000 − 360,000 = $220,000.
  5. Average annual profit = 220,000 ÷ 4 = $55,000.
  6. Average investment = (400,000 + 40,000) ÷ 2 = $220,000.
  7. ARR = 55,000 ÷ 220,000 × 100 = 25%.

Answer: ARR = 25% on average investment.

Example 2

Using the data above, calculate ARR on initial investment. The company's target return is 15%. State your decision and give two limitations of the method.

Show the solution
  1. Average annual profit is $55,000, from the previous calculation.
  2. Initial investment = $400,000.
  3. ARR = 55,000 ÷ 400,000 × 100 = 13.75%.
  4. Compare with the 15% target: 13.75% is below 15%, so the project is rejected on this basis.
  5. Note that on average investment the ARR was 25%, which would be accepted. The choice of base can change the decision, so the target return must be defined on the same base.
  6. Limitation 1: ARR uses accounting profit, which depends on depreciation policy and is not cash flow.
  7. Limitation 2: it ignores the timing of returns and the time value of money, unlike NPV and IRR.

Answer: ARR on initial investment = 13.75%, below the 15% target, so reject on this measure. Limitations: it uses profit not cash, and it ignores the time value of money.

Exam tips

  • In Section A and B objective questions, check whether the question gives accounting profit or cash flow. If cash flow, deduct depreciation first, as there is no partial credit.
  • Always state which base you used, initial or average, in a Section C answer. Method marks depend on it.
  • When asked to evaluate, set ARR against NPV: profit versus cash, no time value, percentage versus absolute value, and dependence on accounting policies.
  • Mention ARR's advantages too: simple, uses familiar accounting figures, links to ROCE used to judge managers.
  • Check the arithmetic by confirming that average profit is lower than average annual cash flow, because depreciation reduces it.

Practice questions from Investment appraisal techniques

Return on Capital Employed (ARR) in other exams

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

Return on Capital Employed (ARR): frequently asked questions

What is the ARR formula in ACCA FM?

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

Is ARR the same as ROCE?

They are closely related. ROCE is usually profit before interest and tax ÷ capital employed for a company. ARR applies a similar idea to a single project, so the method is often called ROCE in investment appraisal.

Why is ARR criticised compared with NPV?

ARR uses accounting profit instead of cash flow and ignores the time value of money. It also gives a percentage, not an absolute value added. Its result depends on depreciation policy and on the choice of investment base.

Should I include depreciation in ARR?

Yes. ARR is based on accounting profit, so depreciation is deducted. If the question gives profit after depreciation, use it as it is.