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Average rate of return
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Before spending money on a project, a business wants to know if it is worth it. The average rate of return compares yearly profit with the cost.
The formula
Average rate of return (%) = average annual profit ÷ cost of investment × 100
Average annual profit = total profit over the life of the investment ÷ number of years
Total profit = total returns − cost of investment.
Average annual profit = total profit over the life of the investment ÷ number of years
Total profit = total returns − cost of investment.
Step by step
A machine costs £50 000 and brings in £80 000 over 5 years.
Total profit = 80 000 − 50 000 = £30 000.
Average annual profit = 30 000 ÷ 5 = £6000.
ARR = 6000 ÷ 50 000 × 100 = 12%.
Total profit = 80 000 − 50 000 = £30 000.
Average annual profit = 30 000 ÷ 5 = £6000.
ARR = 6000 ÷ 50 000 × 100 = 12%.
Using ARR
Compare the ARR of different projects: the higher the better.
Compare with the interest rate a bank would pay: if ARR is lower, the business might do better saving the money.
ARR ignores when the money comes in, and forecasts may be wrong.
Compare with the interest rate a bank would pay: if ARR is lower, the business might do better saving the money.
ARR ignores when the money comes in, and forecasts may be wrong.
A van costs £20 000. Total profit over 4 years is £8000. Find the ARR.
- Average annual profit = 8000 ÷ 4 = £2000
- ARR = 2000 ÷ 20 000 × 100
Answer: 10%
ARR = average annual profit ÷ cost of investment × 100. Average annual profit = total profit ÷ years. Choose the project with the higher ARR, and compare with interest rates.
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