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.… Read the rest