Financial Management and Business Data Analytics · Capital Budgeting

Accounting Rate of Return (ARR) Method in Capital Budgeting

Updated 10 October 2026 · Fact-checked

Accounting Rate of Return (ARR) is the average annual accounting profit after depreciation (and tax, if given) divided by the investment, shown as a percentage. The investment base is either the initial investment or the average investment. Accept the project if ARR is at least the required rate or target rate.

Understand Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) measures the return of a project using accounting profit, not cash flow. It answers one question: on every rupee invested, how much profit does the project earn each year on average?

The profit used is the profit after depreciation. If the question gives tax, use profit after tax. If the question gives cash inflows before depreciation, you must deduct depreciation first. This is where most marks are lost.

The investment base can be taken in two ways. Initial investment means the original outlay (including working capital if the question says it is invested). Average investment means (Initial investment + Scrap value) ÷ 2. Some books also add working capital to the average. Always follow the method the question asks for.

ARR is a non-discounting method. It ignores the time value of money, so a profit in year 5 counts the same as a profit in year 1. It also uses profit, not cash. Its strengths are that it is simple, uses data from accounts, and is linked to return on capital employed. Compare it with the required rate: accept if ARR is higher, and when ranking, pick the highest ARR.

Contrast with payback period: payback measures how fast you recover cash and ignores profits after recovery. ARR looks at the whole life but ignores timing and cash.

Key rules to remember

Average annual profit: Average annual profit = Σ (annual profit after depreciation and tax) ÷ number of years; Annual profit = cash inflow before depreciation − depreciation (− tax, if given).
Depreciation (straight line): Annual depreciation = (Cost − Scrap value) ÷ Life in years; Use it to convert cash inflow into accounting profit.
ARR on initial investment: ARR = Average annual profit ÷ Initial investment × 100; Use when the question says original or initial investment.
Average investment: Average investment = (Initial investment + Scrap value) ÷ 2; If working capital is recovered at the end, treat it like scrap value or add it as the question directs.
ARR on average investment: ARR = Average annual profit ÷ Average investment × 100; The most commonly examined form.
Decision rule: Accept if ARR ≥ required rate; among projects, prefer the higher ARR; Rejects projects below the cut-off.

How to solve Accounting Rate of Return (ARR) questions

Use this order for any ARR question. It keeps the profit figure and the investment base correct.

1Read which base is asked: initial investment or average investment. Note scrap value and working capital.
2Compute annual depreciation = (Cost − Scrap) ÷ Life, unless depreciation is given.
3For each year, find profit = cash inflow (or profit before depreciation) − depreciation. Deduct tax if given.
4Add the yearly profits and divide by the number of years to get the average annual profit.
5Compute the investment base: initial cost, or (Initial + Scrap) ÷ 2 for average.
6Divide the average profit by the base and multiply by 100.
7Compare with the required rate or with other projects, and state the decision in one line.

Quickest way: Total profit shortcut

When to use it: Use when yearly cash flows are uneven or many years are given, and you only need the average.

Total profit over life = Total cash inflows − (Cost − Scrap). Depreciation over life equals Cost − Scrap, so no yearly working is needed.
Subtract total tax if tax is given.
Divide by years to get the average profit.
Divide by the stated base, then multiply by 100.
Check that the result is lower than the cash-based return; if not, you probably forgot depreciation.

Common mistakes in Accounting Rate of Return (ARR)

Using cash inflow as profit without deducting depreciation.
Capital budgeting questions usually give cash flows, so students apply them directly.
Fix: Always ask: is this figure before or after depreciation? Deduct depreciation for ARR.
Taking average investment as half of cost, ignoring scrap value.
Students remember 'divide by 2' only.
Fix: Use (Initial investment + Scrap value) ÷ 2. With zero scrap it becomes half of cost.
Mixing the bases: using average profit with the wrong investment base.
The question does not always state the base clearly, or students skip it.
Fix: Underline the base in the question. If not stated, show both or state your assumption.
Forgetting tax when the question gives a tax rate.
Tax is given at the end of the question and is missed.
Fix: Compute profit before tax, deduct tax, then average. Use profit after tax unless told otherwise.
Dividing by the wrong number of years or averaging only positive years.
Years with low or negative profit are skipped by mistake.
Fix: Include every year of the project life in the total, even if a year's profit is negative.
Claiming ARR considers time value of money or cash flow.
Students confuse it with NPV and IRR.
Fix: Write clearly: ARR is a non-discounting, profit-based method.

Worked examples

Example 1

A machine costs ₹8,00,000 with a scrap value of ₹80,000 after 4 years. Expected annual profit before depreciation and tax is ₹3,00,000. Tax rate is 30%. Depreciation is on straight line. Compute ARR on (a) initial investment and (b) average investment.

Show the solution

Depreciation = (8,00,000 − 80,000) ÷ 4 = ₹1,80,000 per year.
Profit before tax = 3,00,000 − 1,80,000 = ₹1,20,000.
Tax at 30% = ₹36,000. Profit after tax = ₹84,000 per year.
Average annual profit = ₹84,000 (same every year).
(a) ARR on initial investment = 84,000 ÷ 8,00,000 × 100 = 10.5%.
Average investment = (8,00,000 + 80,000) ÷ 2 = ₹4,40,000.
(b) ARR on average investment = 84,000 ÷ 4,40,000 × 100 = 19.09% approximately.

Answer: ARR on initial investment = 10.5%; ARR on average investment ≈ 19.09%.

Example 2

Sarvam Ltd is evaluating a project costing ₹10,00,000 with no scrap value and a 5-year life. Depreciation is straight line. Cash inflows before depreciation (no tax) are: Year 1 ₹3,00,000; Year 2 ₹3,50,000; Year 3 ₹4,00,000; Year 4 ₹3,50,000; Year 5 ₹2,00,000. The company requires an ARR of 20% on average investment. Should it accept the project?

Show the solution

Annual depreciation = 10,00,000 ÷ 5 = ₹2,00,000.
Profits: Year 1 = 1,00,000; Year 2 = 1,50,000; Year 3 = 2,00,000; Year 4 = 1,50,000; Year 5 = 0.
Total profit = 1,00,000 + 1,50,000 + 2,00,000 + 1,50,000 + 0 = ₹6,00,000.
Check by shortcut: total inflows = 16,00,000; less cost 10,00,000 = 6,00,000. Matches.
Average annual profit = 6,00,000 ÷ 5 = ₹1,20,000.
Average investment = (10,00,000 + 0) ÷ 2 = ₹5,00,000.
ARR = 1,20,000 ÷ 5,00,000 × 100 = 24%.
24% is greater than the required 20%.

Answer: ARR = 24%, which exceeds the required 20%, so accept the project. Note that ARR ignores the timing of profits.

Exam tips

Start every answer with the depreciation and profit table. Step marks are given for depreciation, profit and average figures even if the final percentage is wrong.
Read the base carefully. If both bases are asked, show two separate results with labels.
In MCQs, check whether the given figure is profit or cash inflow. Many wrong options are built from forgetting depreciation.
For theory, write three strengths and three weaknesses: simple, uses accounting data, considers whole life; ignores time value, uses profit not cash, no clear base or cut-off.
When asked to compare with payback, state that payback ignores post-recovery cash flows while ARR ignores timing; neither discounts.

Practice questions from Capital Budgeting

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 formula for ARR on average investment?

ARR = Average annual profit after depreciation (and tax) ÷ Average investment × 100. Average investment = (Initial investment + Scrap value) ÷ 2. Use the base the question specifies.

What is the difference between ARR and payback period?

Payback period measures the time to recover the initial outlay from cash flows and ignores cash after that point. ARR measures the average accounting profit as a percentage of investment over the whole life. Neither discounts cash flows, and ARR uses profit rather than cash.

Is ARR a discounting method?

No. ARR is a non-discounting method. It gives equal weight to profits in all years, so it ignores the time value of money.

Do I deduct depreciation when calculating ARR?

Yes. ARR uses accounting profit, which is after depreciation. If the question gives cash inflow before depreciation, subtract depreciation first, and then tax if given.