1. Profit-Based Project Evaluation
Unlike other appraisal methods that track cash movements, the Accounting Rate of Return (ARR) measures a project’s performance using standard accounting profit figures from the projected Income Statement. It expresses the average annual accounting profit as a percentage of the capital investment.
 
2. Core ARR Equation Architecture
To run an ARR calculation, remember to convert project cash flows into accounting profits by deducting annual depreciation costs:
“Average Annual Profit” = “Average Annual Cash Inflows” − “Annual Depreciation Expense”
 
Once calculated, divide this profit by the chosen investment baseline:

ARR (%)=Average Annual Accounting ProfitInitial Capital Investment (or Average Investment)×100

*Note: Average Investment = (Initial Cost + Scrap Value) / 2.
3. Strategic Flaws and Limitations
  • The Cash Flow Violation: ARR violates a core rule of finance by focusing on accounting profits rather than actual cash flows. Profit figures include non-cash adjustments and are easily altered by changing depreciation methods.
  • Time Bias: Like the payback method, ARR ignores the time value of money, treating a $10,000 profit earned in Year 1 exactly the same as a $10,000 profit earned ten years later.

 
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