Accounting Rate of Return (ARR) Method | Advantages | Disadvantages

Advantages of Accounting Rate of Return Method (ARR Method)

The following are the advantages of Accounting Rate of Return method.

1. It is very easy to calculate and simple to understand like pay back period. It considers the total profits or savings over the entire period of economic life of the project.

2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.

3. This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature.

4. This method gives a clear picture of the profitability of a project.

5. This method alone considers the accounting concept of profit for calculating rate of return. Moreover, the accounting profit can be readily calculated from the accounting records.

6. This method satisfies the interest of the owners since they are much interested in return on investment.

7. This method is useful to measure current performance of the firm.

Disadvantages or Weakness or Limitations of Accounting Rate of Return Method

This method has some disadvantages or limitations also. They are briefly explained below.

1. The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions.

2. This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored.

3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the management.

4. This method does not consider the external factors which are also affecting the profitability of the project.

5. It does not taken into the consideration of cash inflows which are more important than the accounting profits.

6. It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be considered to be better than 18% rate of return for 6 years. This is not proper because longer the term of the project, greater is the risk involved.

7. This method cannot be applied in a situation when investment in a project to be made in parts.

8. This method does not consider the life period of the various investments. But average earnings is calculated by taking life period of the investment. As a result, average investment or initial investment may remain the same whether investment has a life period of 4 years or 6 years.

9. It is not useful to evaluate the projects where investment is made in two or more installments at different times.

Related Post

Share the Knowledge: