Inferring the behavior of rainwater harvesting systems and accurate model simulation are crucial for the efficient management of water resources and optimal storage size design in the dry highlands of Ethiopia. Hence optimizing on-farm reservoirs for supplemental irrigation using the water balance model along with economic analysis is a crucial task. The study was carried out in Gondar Zuria district in the Upper Blue Nile River Basin, Ethiopia. The generated optimal reservoir sizing was based on demand-driven operation policies for one year for different inflows, outflows, and losses. The proposed model was implemented under a normal rainfall year, using green pod hot pepper as a test crop. The optimum reservoir size, reliability, marginal rate of return and payback period under actual rainwater harvesting system is 273 m3, 67.7%, 124%, and 15 years, respectively for 0.2 hectare of land. The recommended rainwater harvesting structure will be a 3 m depth trapezoidal structure; 13*13 top dimension, 10*10 bottom dimension with a side slope of 1:1. However, for wet years the reservoir capacity can drop up to 171 m3 with 36 % reliability. In contrast, for dry years the reservoir capacity rises to 399 m3 with 100% and 102.4% reliability and marginal rate of return, respectively. Thus, the study reveals that the rainwater harvesting irrigation system is economically viable in the study area. Moreover, the optimization method is relatively easy to apply and can be used as a decision-support tool for effective management and utilization of water resources.