Accounting Rate of Return (ARR) Method of Capital Budgeting

Accounting Rate of Return (ARR) Method

Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out.

The Accounting Rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.

Accounting Rate of Return (ARR) = Average income / Average investment

There are two variants of the accounting rate of return; Original Investment Method, and Average Investment Method.

1. Original Investment Method. Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average annual profits and original investment established. We can express the ARR in the following way.

Accounting Rate of Return (ARR) = Average annual profits over the life of the project / Original Investment

2. Average Investment Method: Under average investment method, average annual earnings are divided by the average amount of investment. Average investment is calculated, by dividing the original investment by two or by a figure representing the mid-point between the original outlay and the salvage of the investment. Generally accounting rate of return method is represented by the average investment method.

Rate of Return. Rate of Return, as the term is used in our foregoing discussion, may be calculated by taking (a) income before taxes and depreciation, (b) income before tax and after depreciation. (c) income before depreciation an after tax, and (d) income after tax an depreciation, as the numerator. The use of different concepts of income or earnings as well as of investment is made. Original investment or average investment will give different measures of the accounting rate of return.

Merits of Accounting Rate of Return (ARR) Method

The following are the merits of the accounting rate of return (arr) method of capital budgeting.

  1. It is very simple to understand and use.
  2. Rate of return may readily be calculated with the help of accounting data.
  3. They system gives due weight age to the profitability of the project if based on average rate of return. Projects having higher rate of Return will be accepted and are comparable with the returns on similar investment derived by other firm.
  4. It takes investments and the total earnings from the project during its life time.

Demerits of Accounting Rate of Return (ARR) Method

The accounting rate of return (arr) method of capital budgeting suffers from the following weaknesses.

  1. It uses accounting profits and not the cash-inflows in appraising the projects.
  2. It ignores the time-value of money which is an important factor in capital expenditure decisions. Profits occurring in different periods are valued equally.
  3. It considers only the rate of return and not the length of project lives.
  4. The method ignores the fact that profits can be reinvested.
  5. The method does not determine the fair rate of return on investment. It is left at the discretion of the management. So, use of arbitrary rate of return cause serious distortion in the selection of capital projects.
  6. The method has different variants, each of which produces a different rate of return for one proposal due to the diverse version of the concepts of investment and earnings.

It is clear from the above discussion that the accounting rate of return (arr) method is not much useful except in evaluating the long-term capital proposals.

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