Calculating Average Rate of Return (ARR)
Method and Worked Example
The ARR method calculates the average annual percentage return an investment provides for a business.
Investment options can be compared using this method, with the investment returning the highest ARR
chosen. For example, if the ARR for Project A was 15% and for Project B was 20%, then Project B would be
chosen because the ARR percentage is higher than Project A.
The technique used for calculating ARR is as follows:
1. Divide the net profit generated by an investment by the number of years the project is expected to
last (this is the average annual return)
2. Divide the average annual return (your answer to 1.) by the initial outlay / cost of investment
3. Multiply your answer by 100 to give the ARR as a percentage.
Suzy Reason owns a business manufacturing fragranced candles. Suzy is looking to expand her business
and to do this she will need to buy some new machinery to help produce more fragranced candles. Suzy has
searched online and found two machines that are suitable to help her achieve increased output. The cost of
buying each machine and the annual estimated net profits are provided in the table below:
Candle Wizard Cost
£90 000
Wax Wonder Cost
£110 000
Year 1 net profit £20 000 £10 000
Year 2 net profit £30 000 £20 000
Year 3 net profit £40 000 £40 000
Year 4 net profit £20 000 £60 000
Year 5 net profit £20 000 £50 000
Total net profit £130 000 £180 000
To calculate the ARR for the Candle Wizard and Wax Wonder:
Candle Wizard Wax Wonder
Divide the total net profit by the
number of years
£130 000
5 years
£180 000
5 years
Annual average return = £26 000 = £36 000
Divide the average annual return
by the initial outlay / cost of
investment
£26 000
£90 000
£36 000
£110 000
= 0.289 (3 d.p.) = 0.327 (3 d.p.)
Multiply result by x 100 to give
ARR % 28.9% (1 d.p.) 32.7% (1 d.p.)
Based on the results above, Suzy would be advised to choose the Wax Wonder as this has the highest ARR.
