Average Rate of Return

Definition

Average Rate of Return is an investment appraisal metric that expresses the average annual accounting profit generated by an investment as a percentage of the initial investment or average investment value.

What is Average Rate of Return?

Average Rate of Return, often called ARR in capital appraisal, is a profitability measure used to judge whether an investment appears attractive on an accounting basis. It does not focus on cash inflows and discounting. Instead, it looks at the average annual accounting profit the project is expected to generate over its life.

In practice, ARR is often used in capital budgeting discussions because it is easy to explain to nonfinance stakeholders and aligns naturally with accounting profit reporting. It is commonly seen in business cases for equipment, software, automation, facilities, or process improvement projects.

In procurement and finance, ARR matters when sourcing choices affect the economics of investment decisions. Price, implementation cost, service charges, maintenance terms, and asset life assumptions all influence the accounting return presented to decision makers.

How to Calculate Average Rate of Return

A common formula is average annual accounting profit divided by the initial investment, multiplied by 100. Some organizations use average investment instead of initial investment, depending on internal capital appraisal policy.

For example, if a project is expected to generate total accounting profit of 600,000 over six years, the average annual accounting profit is 100,000. If the initial investment is 1,000,000, the ARR is 10.0%. If the company uses average investment instead, the resulting percentage will differ, which is why the chosen formula must be stated clearly in the business case.

Average Rate of Return vs Internal Rate of Return

ARR uses accounting profit and ignores the time value of money. Internal Rate of Return uses cash flows and discounting to reflect timing. Because of that, ARR is simpler but less economically complete for long horizon decisions.

Two projects can have the same ARR while having very different cash flow timing, risk, and financing implications. That is why ARR is often used as a screening measure rather than as the sole investment criterion.

Average Rate of Return in Procurement

Procurement teams contribute to ARR whenever they influence the cost base of an investment. This includes equipment purchases, implementation services, software licensing structures, maintenance contracts, logistics automation, and operational improvement projects. Even when finance owns the final calculation, procurement shapes the commercial assumptions behind it.

That means sourcing decisions can change whether a project appears to clear the required return threshold, especially where supplier terms affect depreciation base, operating cost, or ongoing support charges.

Benefits of Average Rate of Return

ARR is easy to communicate, quick to calculate, and intuitive for stakeholders who think in accounting profit terms. It can be useful for ranking smaller projects or for supplementing more advanced discounted cash flow analysis with a simple profitability percentage.

It also provides a common language between commercial teams and finance when business cases need a straightforward return measure that does not require advanced modeling to understand.

Limitations of Average Rate of Return

The biggest limitation is that ARR ignores the time value of money. It also depends on accounting profit, which can be affected by depreciation policy and other accounting treatments rather than pure economic reality. As a result, it can make weak investments look acceptable if timing and cash flow risk are not considered separately.

For material capital decisions, ARR is usually best treated as one input among several rather than as a definitive measure on its own.

Frequently Asked Questions about Average Rate of Return

How is Average Rate of Return calculated in practice?

It is usually calculated by dividing average annual accounting profit by either the original investment or the average investment value, then multiplying by 100. The important point is that the business case must state clearly which denominator is being used. Without that, ARR results from different projects may not be comparable even if they appear to use the same metric.

Why is Average Rate of Return different from Internal Rate of Return?

The two metrics answer different questions. ARR measures accounting profit relative to investment size, while Internal Rate of Return measures the discount rate at which future cash flows break even in present value terms. ARR is simpler and easier to explain, but IRR usually gives a stronger view of economic attractiveness when timing of cash flows matters.

Is Average Rate of Return a cash flow measure?

No. It is an accounting profit measure. That distinction matters because profit and cash are not the same thing. A project can produce an acceptable ARR while still placing pressure on liquidity if cash outflows happen early and cash inflows arrive much later. Finance teams therefore usually pair ARR with cash flow based metrics.

When is ARR useful in procurement related business cases?

ARR is useful when evaluating capital purchases such as machinery, software platforms, warehouse automation, or process improvement projects where stakeholders want a simple annual return percentage. Procurement often supplies the pricing, implementation, maintenance, and lifecycle assumptions that determine whether the projected accounting return looks acceptable under the investment policy and approval threshold.

What are the main weaknesses of Average Rate of Return?

The main weaknesses are that it ignores the time value of money, depends on accounting assumptions, and may oversimplify projects with uneven returns over time. It can be useful as a communication tool, but for major decisions it should be supported by net present value, internal rate of return, payback analysis, or other measures that better reflect cash timing and economic risk.