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Average Rate of Return
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Average rate of return
A complete guide to Average Rate of Return — covering investment appraisal, average annual profit, initial investment, ARR calculations and how businesses compare investment projects.
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Created by an experienced Head of Business and examiner
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KEY POINTS
Average Rate of Return measures the average annual accounting profit from an investment as a percentage of the initial investment.
ARR is a method of investment appraisal used to compare different projects.
The higher the ARR, the more financially attractive the investment may appear.
ARR uses accounting profit rather than cash flow.
ARR helps businesses judge the profitability of an investment over its lifetime.
ARR can be compared with a target rate of return set by the business.
ARR is easy to calculate and understand.
ARR does not consider the timing of returns or the time value of money.
KEY DEFINITION
Average Rate of Return
Average Rate of Return is an investment appraisal method that measures the average annual accounting profit from a project as a percentage of the initial investment.
Main Explanation
Average Rate of Return
Average Rate of Return, often shortened to ARR, is a method of investment appraisal. It helps a business estimate the average annual profit from an investment project.
ARR is shown as a percentage, which makes it useful when comparing different investment options.
How ARR is calculated
To calculate ARR, a business first works out the total accounting profit expected over the life of the project. This is then divided by the number of years to find the average annual profit.
The average annual profit is then divided by the initial investment and multiplied by 100.
Why ARR is useful
ARR is useful because it looks at the profit made over the whole life of a project. This makes it different from payback period, which only shows how long it takes to recover the original investment.
A project with a longer payback period may still be attractive if it produces strong profits over time.
Using ARR to make decisions
Businesses often compare ARR with a target rate of return. For example, if a business wants investments to achieve at least 20% ARR, a project with an ARR of 25% may be seen as financially attractive.
ARR can also help managers compare several projects and choose the one with the highest average return.
Limitations of ARR
ARR has limitations. It uses accounting profit rather than cash flow, so it does not show how quickly money is received.
It also ignores the timing of returns and the time value of money. This means ARR should not be used on its own. It is often better to use it alongside methods such as payback period and net present value.
Overall judgement
ARR is a useful way to compare the profitability of investment projects. However, the best decision will also depend on cash flow, risk, timing, business objectives and whether the figures are realistic.
✎ EXAMINER TIP
Students often confuse ARR with payback. ARR measures the average annual percentage return from an investment, while payback measures how long it takes to recover the initial cost. Always check whether the question is asking for profitability or speed of recovery.
KEY FORMULAS(s)
Profit and Profitability Formulas
These key formulas help you calculate different profit measures and profitability ratios used in business.
Gross Profit
Gross profit = Revenue − Cost of sales
The profit made after deducting direct costs.
!
Remember: profit shows how much money has been made, while profitability shows how efficiently revenue is being turned into profit.
DATA TABLE
Income Statement for North Coast Coffee Ltd
This statement shows how revenue is converted into gross profit, operating profit and net profit.
Revenue
£250,000
Output
Fixed Costs
Variable Costs
Total Costs
Revenue
Profit / Loss
0 candles £1,200 £0 £1,200 £0 -£1,200
Net profit is the final profit remaining after all costs and expenses have been deducted from revenue.
WORKED EXAMPLE
Worked Example: North Coast Coffee
How many coffees must be sold to break even?
Fixed Costs
£1,800
equity + long-term debt
Break-even output = Fixed costs ÷ Contribution per unit
Contribution per unit = Selling price − Variable cost
£3.50 − £1.10 = £2.40
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Step 1: Calculate contribution
£3.50 − £1.10 = £2.40
Contribution per unit is the amount each coffee contributes towards fixed costs.
BREAK-EVEN OUTPUT:
750 coffees per month
EXAM TIP
Always explain what the number means for the business. Do not just calculate the break-even point.
The ARR Calculation
APPLICATION
Amazon
Amazon is a global e-commerce and technology business that invests heavily in fulfilment centres, delivery systems, warehouse robotics and cloud technology. These investments often cost a large amount upfront but may improve efficiency, increase capacity and generate returns over several years.
Average Rate of Return could help Amazon compare different investment projects by showing the average annual profit as a percentage of the original investment. For example, Amazon could use ARR to compare investment in warehouse robotics with investment in delivery technology or new fulfilment capacity.
This makes ARR useful because it gives managers a simple percentage return to compare. However, Amazon should not rely on ARR alone because it does not show how quickly the investment is recovered or when the returns are received.
This independent educational case study is not affiliated with, endorsed by or sponsored by Greggs plc. Any financial figures used alongside this example should be treated as simplified or hypothetical estimates created for teaching purposes.
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ANALYSIS
EXAM FOCUS
Analysis questions require you to examine a business concept or issue in detail, breaking it down into its component parts. You should explain how and why something happens and consider its impact on the business.
How to Approach Analysis Questions
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Identify the key issue or concept
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Break it down
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Explain how and why
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Reach a reasoned conclusion
Read the question carefully and highlight the focus of the analysis.
Consider the different factors, causes or impacts related to the issue.
Provide clear explanations using business terms and links points to context.
Evaluate the overall implications for the business.
Example Analysis Question
North Coast Coffee is considering using break-even analysis before opening a second café.
Advantages
• Sales forecasts may be inaccurate.
• Assumes costs and revenue remain constant.
• External factors may reduce reliability.
• Ignores qualitative business factors.
Disadvantages
• Sales forecasts may be inaccurate.
• Assumes costs and revenue remain constant.
• External factors may reduce reliability.
• Ignores qualitative business factors.
Key Exam Tip
If you find it difficult to expand your answer and show the type of depth that an examiner is looking for in a top response, consider using the 'so what' approach.
Tesco carry out market research - so what? - this allows them to better understand customer needs - so what? as a result Tesco can provide goods more likely to sell - so what? - this will increase Tesco profit and ensure higher levels of customer satisfaction - so what? this means that customers are likely to become more loyal to Tesco.
Avoid These Exam Traps
Students often lose marks on calculation and analysis questions by making these mistakes. Watch out for them in your exam!
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Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Tip:
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
2
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Tip:
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
3
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Tip:
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Be precise. Read the question carefully. Show your working.
Small mistakes can cost big marks.
EXAM PRACTICE
Practice Question
Apply your knowledge of profit and profitability to answer this exam-style question.
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MINI CASE STUDY
North Coast Coffee Ltd is a premium coffee business which sells freshly roasted coffee beans through its online store and a small chain of independent cafés. The business has experienced strong sales growth due to increasing demand for high-quality speciality coffee products.
The business generates annual revenue of £250,000. Its cost of sales, including coffee beans, packaging and direct production costs, totals £100,000. North Coast Coffee Ltd also faces operating expenses of £80,000, including marketing, employee wages, rent and administration costs. In addition, the business pays £20,000 in interest and taxation each year.
The owner, Mia Thompson, is reviewing the company’s profitability because rising wage costs and increased competition in the premium coffee market have started to place pressure on operating profit margins. She is considering increasing prices slightly in order to protect profitability while still maintaining customer demand.
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EXAM QUESTION
Analyse the possible reasons for BrightBite’s falling profit margins and evaluate strategies it could use to improve profitability.
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HOW TO ANSWER
P
Point
E
Explain
A
Apply
C
Consequence
H
However...
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MODEL ANSWER
P
Point
Increasing prices could improve the profitability of North Coast Coffee Ltd because each sale would generate a larger amount of revenue and potentially increase profit margins.
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EXAMINER TIP
For full marks, make sure you analyse causes rather than just listing them, and evaluate realistic strategies with clear judgement. THINK: Which strategy would have the biggest impact and why?
CALCULATOR
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