Financial Management and Strategic Management · Investment Decisions

Accounting Rate of Return (ARR): Formula and Calculation

Updated 4 October 2026 · Fact-checked

Accounting Rate of Return (ARR) is the average annual accounting profit after depreciation and tax, expressed as a percentage of the investment. You can use the average investment or the initial investment. Compute average profit, pick the base the question asks for, divide, and compare with the target rate.

Understand Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) tells you how much profit a project earns each year, in percentage terms, on the money put into it. It uses accounting profit, not cash flow.

Start with the profit. Take each year's profit after depreciation (and after tax, if the question gives tax). Add up the profits over the project life and divide by the number of years. This gives the average annual profit.

Next, choose the investment base. The average investment is the mean of the money tied up in the project over its life. With straight-line depreciation, it is (Initial investment + Salvage value) ÷ 2 when there is no working capital. Some questions use the initial investment instead. Read the question to see which one it wants.

Divide average profit by the base and multiply by 100. If ARR is higher than the target or cut-off rate, accept the project. When you rank projects, the higher ARR is better.

ARR is easy to compute and links to the books of account. But it ignores the time value of money and uses profit instead of cash. It also does not look at when the profits arrive. That is why NPV and IRR are preferred, and why examiners ask you to state these limitations.

Key rules to remember

ARR on average investment: ARR = Average annual profit after depreciation (and tax) ÷ Average investment × 100; Use this when the question asks for average investment. If the question does not name the base, state which base you have used.
ARR on initial investment: ARR = Average annual profit after depreciation (and tax) ÷ Initial investment × 100; Use when the question asks for it or defines ARR this way.
Average annual profit: Average profit = Σ (annual profits after depreciation and tax) ÷ Number of years; If profits are given before depreciation, deduct depreciation first.
Average investment (with salvage): Average investment = (Initial investment + Salvage value) ÷ 2; Valid for straight-line depreciation when there is no working capital.
Average investment (with working capital): Average investment = (Cost + Salvage value) ÷ 2 + Working capital; Working capital stays tied up throughout the project, so it is added in full and not halved.
Decision rule: Accept if ARR ≥ target rate; for ranking, choose the highest ARR; Mutually exclusive projects: pick the higher ARR if it is above the cut-off.

How to solve Accounting Rate of Return (ARR) questions

Use this order for any ARR question. It keeps the working clean and earns step marks.

1Read which investment base is asked for: average or initial. Note any salvage value, working capital and tax rate.
2Find annual depreciation = (Cost − Salvage value) ÷ Life, unless another method is given.
3Prepare a profit statement for each year: profit before depreciation and tax, less depreciation, less tax, equals profit after tax.
4Add the yearly profits after tax and divide by the number of years to get average annual profit.
5Compute the base. Average investment = (Cost + Salvage) ÷ 2, plus working capital if given. Or use initial investment if asked.
6Divide average profit by the base and multiply by 100.
7Compare with the target rate and give a one-line decision.
8If asked, add one or two limitations of ARR, such as ignoring time value of money.

Quickest way: Fast ARR under time pressure

When to use it: Use for MCQs and for the calculation part of written answers when profit is level or the data is simple.

Write down average profit first. If profit is the same every year, that is your average.
Write the base next in one line: (Cost + Salvage) ÷ 2, plus working capital if any.
Divide, then recheck the answer against the base and the profit you used.
For MCQs, look for options that use the wrong base, such as initial cost. Check which base the stem asks for.
Check that depreciation was deducted. An option based on profit before depreciation is usually a trap.
In written answers, show the profit table, then the base, then the ratio. Each line earns a step mark.

Common mistakes in Accounting Rate of Return (ARR)

Using profit before depreciation.
Cash-flow thinking from NPV carries over, and students pick the first profit figure given.
Fix: ARR uses accounting profit. Always deduct depreciation, and tax if given, before averaging.
Using initial investment when the question wants average investment.
Students rush and take the cost figure directly from the question.
Fix: Underline the base the question names. If it is not named, show average investment and state that you have used it.
Forgetting salvage value in average investment.
Students halve the cost and stop.
Fix: Use (Cost + Salvage) ÷ 2. Salvage value is still tied up at the end of the project.
Treating working capital as depreciable or halving it.
Students include working capital in cost and then apply the average formula to everything.
Fix: Working capital stays invested all through the life, so add it in full to the average of the fixed asset.
Dividing total profit by the base without averaging over the years.
The total profit looks like the profit figure, and the step is skipped under time pressure.
Fix: Always divide total profit by the number of years first.
Saying ARR considers time value of money.
Students confuse ARR with IRR or NPV because all three are percentages or rates of return.
Fix: ARR is not discounted. It treats profit in every year equally.

Worked examples

Example 1

A machine costs ₹10,00,000 and has a life of 5 years with a salvage value of ₹1,00,000. Depreciation is straight line. Profit before depreciation and tax is ₹4,00,000 each year. Tax rate is 30%. Compute ARR on average investment.

Show the solution

Annual depreciation = (10,00,000 − 1,00,000) ÷ 5 = ₹1,80,000.
Profit before tax = 4,00,000 − 1,80,000 = ₹2,20,000.
Tax at 30% = ₹66,000, so profit after tax = ₹1,54,000 each year.
Average annual profit = ₹1,54,000, since it is the same every year.
Average investment = (10,00,000 + 1,00,000) ÷ 2 = ₹5,50,000.
ARR = 1,54,000 ÷ 5,50,000 × 100 = 28%.

Answer: ARR on average investment = 28%.

Example 2

A project needs a machine costing ₹8,00,000 (no salvage value, life 4 years, straight-line depreciation) and working capital of ₹2,00,000. Profits after depreciation and tax for years 1 to 4 are ₹1,00,000, ₹1,40,000, ₹1,80,000 and ₹1,80,000. Compute ARR on (a) initial investment and (b) average investment.

Show the solution

Total profit = 1,00,000 + 1,40,000 + 1,80,000 + 1,80,000 = ₹6,00,000.
Average annual profit = 6,00,000 ÷ 4 = ₹1,50,000.
Initial investment = 8,00,000 + 2,00,000 = ₹10,00,000.
(a) ARR on initial investment = 1,50,000 ÷ 10,00,000 × 100 = 15%.
Average investment = (8,00,000 ÷ 2) + 2,00,000 = ₹6,00,000, because working capital is added in full.
(b) ARR on average investment = 1,50,000 ÷ 6,00,000 × 100 = 25%.

Answer: (a) 15% on initial investment; (b) 25% on average investment.

Exam tips

Check the base before you start. The same data gives different ARR on initial and average investment.
Show the yearly profit table even when profits are equal. It earns step marks.
In MCQs, test each option against the common traps: profit before depreciation, no salvage value, and wrong base.
If the question asks you to compare ARR and payback, say that ARR measures profitability and ignores time value, while payback measures how fast cost is recovered and ignores profits after payback.
Add a one-line decision against the cut-off rate to close the answer.

Practice questions from Investment Decisions

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 CA Intermediate?

ARR = Average annual profit after depreciation (and tax) ÷ Investment × 100. The investment is either the average investment or the initial investment, depending on the question. Average investment is (Cost + Salvage) ÷ 2, plus working capital if given.

How do I calculate ARR on average investment?

First find average annual profit after depreciation and tax. Then compute average investment as (Cost + Salvage) ÷ 2, adding working capital in full if any. Divide profit by this base and multiply by 100.

What is the difference between ARR and payback period?

ARR gives the percentage return based on accounting profit. Payback gives the time taken to recover the initial outlay from cash flows. ARR uses profit over the whole life; payback ignores cash flows after the payback point. Neither considers time value of money, unless discounted payback is used.

What are the limitations of ARR?

It ignores time value of money and uses accounting profit instead of cash flow. It also depends on the depreciation method and on how the investment base is defined, so take the base as the question specifies. It does not show the size of the project's value addition, so NPV is better.