Average rate of return

The average rate of return (ARR) measures how profitable an investment or capital project is expected to be. It shows the average annual profit as a percentage of the money spent to set the project up, so you can judge whether a project is worth the money it costs.

The formula

ARR (%) = (average annual profit ÷ cost of investment) × 100

The cost of investment is the initial amount the project costs to start, such as the price of a new refrigerated van. Average annual profit is the total profit the project is expected to make over its whole life, shared out evenly across the years:

Average annual profit = total profit ÷ number of years

1. Find the total profit over the project's life.
2. Divide it by the number of years to get the average annual profit.
3. Divide that by the cost of investment.
4. Multiply by 100 to turn it into a percentage.

Worked example

A farm shop spends £80,000 on a new cold storage room. It expects the room to make £128,000 of profit in total over 8 years.

• Average annual profit = £128,000 ÷ 8 = £16,000
• ARR = (£16,000 ÷ £80,000) × 100 = 20%

Write the final answer as a percentage, such as 20%, not as a money amount. If a question asks for a set number of decimal places, round to exactly that many: 27.55% to one decimal place is 27.6%.

Using ARR to make decisions

The higher the ARR, the more profitable the investment is expected to be for each pound spent. A business can compare the figure with a target return it has set, or with the ARR of rival projects, and pick the one offering the best return.

ARR is only an estimate because it uses forecast profits. The real return may differ, and a business may still choose a project with a lower ARR if it brings other benefits, such as faster production or a stronger reputation.