Accounting Rate of Return (ARR) method is also known as average rate of return an average of the net profit after taxes over the whole of the economic life of the project is taken. Under this method, the performance is expected as a percentage of capital or investment. Accounting rate of return may be calculated according to any of the following methods.
- In the case of independent projects, calculated Accounting Rate of Return of the project will be compared with standard ARR set by the company. If the calculated ARR is more than usual ARR, it will be accepted otherwise rejected.
- While evaluating mutually exclusive projects calculated ARR of the alternatives will be compared to judge the profitability. The project which has a higher rate of return will be accepted.
- In case of capital rationing situation, the projects are ranked and selected. The projects which have higher rate will be given top ranks and selected in order of priority.
Advantages of Accounting Rate of Return:
- ARR is very simple to understand and easy to calculate.
- It uses the entire earnings of a project in calculating the rate of return.
- ARR method is based upon accounting concept of profit. It can be readily calculated firm financial data.
Disadvantages of Accounting Rate of Return:
- ARR method is like payback period method, ignores the time value of money.
- It doesn’t take into consideration the cash flows which are more critical than the accounting profits.
- It ignores the timing of returns.
- This method can’t be applied to a situation where investment in a project is to be made in parts.