Budgeting

Advantages and Disadvantages of Accounting Rate of Return Method

Accounting Rate of Return Method is otherwise known as Financial Statement Method or Un-adjusted Rate of Return Method. According to this method, capital projects are ranked in order of earnings. Projects which yield the highest earnings are selected and others are ruled out. Accounting Rate of Return Method is sub-divided into many others like ARR  or Average Rate of Return Method, Earning per unit, average investment etc.

The Accounting return on investment method can be expressed in several ways as follows:

(i) Average Rate of Return Method – Under this method we calculate the average annual profit and then we divide it by the total outlay of capital project. Thus, this method establishes the ratio between the average annual profits and total outlay of the project. As per formulae,

Rate of Return = Average Annual Profits /Outlay of the Project

Thus, the average rate of return method considers whole earnings over the entire economic life of an assets. Higher the percentage of return, the project will be acceptable.

(ii) Earnings per unit of Money Invested : As per this method, we find out the total net earnings and then divide it by the total investment. This gives us the average rate of return per unit of amount invested in the project. As per formulae :

Earning per unit of invested=Total Earnings/ Total Outlay of the Project

The higher the earnings per unit, the project deserves to be selected.

(iii) Return on Average Amount of Investment Method – Under this method the percentage return on average amount of investment is calculated. To calculate the average investment the outlay of the project is divided by two. As per formulae:

Average Investment = (Unrecovered Capital at the beginning + unrecouped capital at the end)/2 (OR)

Average Investment =Initial Investment + Scalp value/ 2 (OR)

Average Investment =Investment /2 (This formulae should be used only when the equipment has no salvage value.)

Rate of Return= (Average Annual Net Income (Savings)² x 100 )/Average Investment

Here : Average Annual Net Income = Average Annual Cash-inflow minus Depreciation

Thus, we see that the rate of return approach can be applied in various ways. But, however, in our opinion the third approach is more reasonable and consistent.

Advantages of Accounting Rate of Return Method

This approach has the following advantages of its own :

(1) Like payback method it is also simple and easy to understand.

(2) It takes into consideration the total earnings from the project during its entire economic life.

(3) This approach gives due weight to the profitability of the project.

(4) In investment with extremely long lives, the simple rate or return will be fairly close to the true rate of return. It is often used by financial analysis to measure current performance of a firm.

Disadvantages of Accounting Rate of Return Method

(1) One apparent disadvantage of this approach is that its results by different methods are inconsistent.

(2) It is simply an averaging technique which does not take into account the various impacts of external factors on over-all profits of the firm.

(3) This method also ignores the time factor (time value of money) which is very crucial in business decision.

(4) This method does not determine the fair rate of return on investments. It is left at the discretion of the management. So, use of this arbitrary rate of return may welt cause serious distortions in the selection of capital projects.

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