The accounting rate of return (ARR) appraisal method is also known as the return on investment (ROI) or return on assets (ROA) method. It is calculated by dividing a project’s average accounting profits by its average investment. The average profits figure is found by adding up the profits for each year of the investment and dividing by the number of years.
The average investment is the sum of the initial investment or outlay plus the expected residual or realizable value of the asset, divided by two. A variation on the above is to calculate the ARR by substituting the initial investment for the average investment in the denominator. This will yield a lower percentage rate of return figure than the former method. Sometimes the measure will also be calculated using after-tax profits in the numerator of the equation.
Many firms will set a minimum or target ARR for projects and will use this as their decision rule. Thus, the decision rule using ARR is: “If the actual ARR is less than the minimum required ARR, the project is not acceptable; if the actual ARR is greater than, or equal to, the minimum required ARR, the project is acceptable.” The advantages of ARR are: it does suggest something about a project’s profitability, which payback does not, and it is simple to use and easy to understand by business people. The major limitations of ARR are: it ignores cash flows, the timing of returns, and the time value of money. Despite its weaknesses, the ARR is widely used in practice as return on investment (ROI) or capital employed (ROCE) is a preferred performance measure with business people.