Published On:Thursday, 22 December 2011
Posted by Muhammad Atif Saeed
The accounting rate of return method
ARR overview:
The Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage of the capital outlay.
The capital outlay (the denominator in the ARR calculation) may be expressed as the initial investment or as the average investment in the project.
The decision rule is that projects with an ARR above a defined minimum are acceptable; the greater the ARR, the more desirable the project.
The main advantage of the ARR is that it is simple to calculate and understand. However it does have a number of major disadvantages.
The main disadvantage of the ARR is that it does not take account of the timing of the profits from a project.
Calculating the accounting rate of return:
The accounting rate of return (ARR) method of appraising a project involves estimating the accounting rate of return that a project should yield. If it exceeds a target rate of return then the project is acceptable.
There are two different ways of calculating the ARR.
ARR =Average annual accounting profit / Initial investment × 100%
ARR = Average annual accounting profit / Average investment × 100%
The average investment is calculated as ½ (initial investment + final or scrap value).
The advantages and disadvantages of the ARR method of project appraisal:
The ARR method has the serious disadvantage that it does not take account of the timing of the profits from a project. Whenever capital is invested in a project, money is tied up until the project begins to earn profits which pay back the investment. Money tied up in one project cannot be invested anywhere else until the profits come in. Management should be aware of the benefits of early repayments from an investment, which will provide the money for other investments.
There are a number of other disadvantages.
- It is based on accounting profits rather than cash flows, which are subject to a number of different accounting policies
- It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.
- It takes no account of the length of the project
- Like the payback method, it ignores the time value of money
There are, however, advantages to the ARR method.
- It is quick and simple to calculate
- It involves a familiar concept of a percentage return
- Accounting profits can be easily calculated from financial statements
- It looks at the entire project life
