Accounting rate of return (ARR) is commonly known as a simple rate of return which focuses on the project’s net income rather than its cash flow. It is one of the oldest evaluation techniques. In its most commonly used form, the accounting rate of return is measured as the ratio of the project’s average annual expected net income to its average investment.
The accounting rate of return formula is as follows
Accounting Rate of Return (ARR) = Average Accounting Profit / Average Investment
The first element, average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's lifetime.
The next element, the average investment is calculated as the sum of the beginning and ending book value of the project divided by 2. Another alternative of ARR formula uses initial investment instead of average investment.
An initial investment of Tk 130,000 by an Indonesian company MAX Ltd in Bangladesh is expected to generate annual revenue of Tk 32,000 for 6 years. Depreciation is allowed on a straightline basis. Further it is estimated that the project will have salvage value of Tk 10,500 at end of the 6th year.
The accounting rate of return assuming that there are no other expenses on the project would be as follows:
Steps 
Description 
Formula 
Workings 
Step 1 
Average Investment per year (Depreciation) 
[ Initial Investment () Scrap Value] / Useful Life in Years 
( Tk 130,000 – Tk 10,500 ) / 6 = Tk 19,917 
Step 2 
Average Accounting profit 
Annual Revenue – (Annual depreciation + Expenses) 
Tk 32,000  Tk 19,917 = Tk 12,083 
Step 3 
Accounting Rate of Return ( ARR ) ( in percentage ) 
Average Accounting profit/ Average Investment (Initial Value + Book Value at end /2) 
Tk 12,083 / Tk 70,250 = 17.2% 
The accounting rate of return of MAX Ltd from this project will be 17.2%.
The decision rule is simple that the ARR calculations will choose only those projects which have equal or greater accounting rate of return compared to required rate of return.
In case of mutually exclusive projects, the accounting rate of return calculations will choose the project with highest ARR. Let us understand this with an example.
Rajesh Ltd of India has two mutually exclusive projects to be laid in UAE. The details of cash inflows and outflows are as follows : 
Project A 

Time 
Cash Inflow 
Cash outflow 
Other details 
Year 0 

220 Dirhams 

Year 1 
91 Dirhams 

SLM Deprecation 
Year 2 
130 Dirhams 

SLM Depreciation 
Year 3 
105 Dirhams 

SLM Deprecation 
Project B 

Time 
Cash Inflow 
Cash outflow 
Other details 
Year 0 

198 Dirhams 

Year 1 
87 Dirhams 

SLM Deprecation 
Year 2 
110 Dirhams 

SLM Depreciation 
Year 3 
84 Dirhams 

SLM Deprecation 
Average Rate of Return calculations of both the projects are below:
Project A
Steps 
Description 
Formula 
Workings 
Step 1 
Annual Depreciation 
[ Initial Investment (  ) Scrap Value ] / ( Useful Life in Years ) ] 
[ 220 (  ) 10 ] / 3 = 70 
Step 2 
Average Accounting Profit 
Average of Net Income = Inflows (  ) Outflows 
[ ( 91 – 70 ) + ( 130 – 70 ) + ( 105 – 70 ) ] / 3 = 38.67 
Step 3 
Accounting Rate of Return ( ARR ) ( in percentage ) 
Average Accounting profit/ Average Investment (Initial value + Book value at end /2) 
42 / 115 = 33.62% 
Project B
Steps 
Description 
Formula 
Workings 
Step 1 
Annual Depreciation 
[ Initial Investment (  ) Scrap Value ] / ( Useful Life in Years ) ] 
[ 30% (  ) 18 ] / 3 = 60 
Step 2 
Average Accounting Profit 
Average of Net Income = Inflows (  ) Outflows 
[ ( 87 – 60 ) + ( 110 – 60 ) + ( 84 – 60 ) ] / 3 = 33.67 
Step 3 
Accounting Rate of Return ( ARR ) ( in percentage ) 
Average Accounting profit / Average Investment (Initial Value + Book Value at end /2) 
33.67 / 108 = 31.17.% 
Project A with higher ARR is the one which Rajesh Ltd will choose. This because, in the case of mutually exclusive projects, the accounting rate of return calculations will choose the project with the highest ARR.
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