Accounting Rate of Return: The Simple Project-Profitability Screen

The accounting rate of return (ARR) is a project-evaluation metric that compares expected accounting profit with the investment required.

It is widely known because it is simple. It is also limited because it relies on accounting profit instead of discounted cash flow.

How ARR Is Calculated

A common version is:

Some firms use average investment in the denominator instead of initial investment, so the exact formula can vary by company policy.

Worked Example

Suppose a project requires an initial investment of $200,000 and is expected to generate average annual accounting profit of $30,000.

The project’s accounting rate of return is 15%.

Why Managers Still Use It

ARR remains popular because it is:

• easy to compute
• easy to explain
• built from accounting numbers managers already report

It can be useful as a quick first screen or as a reporting metric inside organizations that think in terms of accounting profit targets.

Its Biggest Weaknesses

ARR has real limitations.

It ignores the time value of money

A dollar earned early is treated the same as a dollar earned later.

It focuses on accounting profit, not cash flow

Depreciation, accruals, and other accounting conventions can affect the result.

It can mislead in capital budgeting

Projects with strong ARR may still have weak economics once timing and cash flow are analyzed properly.

That is why serious investment decisions usually rely more heavily on net present value (NPV) and internal rate of return (IRR).

ARR vs. NPV and IRR

ARR asks:

• how much accounting profit does this project generate relative to investment?

NPV and IRR ask:

• what are the discounted cash-flow economics of the project?

That makes ARR easier to compute, but usually less reliable for ranking competing long-term investments.

When ARR Can Still Be Useful

ARR can still help when:

• managers need a quick profitability screen
• the firm wants a simple internal benchmark
• the analysis is supplementary rather than decisive

It becomes dangerous when it replaces discounted cash-flow analysis for major capital allocation decisions.

Related Terms

• Net Present Value (NPV): A discounted cash-flow measure of value creation.
• Internal Rate of Return (IRR): The discount rate that sets NPV to zero.
• Capital Budgeting: The decision process where ARR is sometimes used as a quick screen.
• Discount Rate: Central to the discounted methods ARR leaves out.
• Balance Sheet: Where the investment itself and related accounting effects are reflected.

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