Advantages and Disadvantages of ARR

Accounting rate of return (ARR) is a method of comparing the average profits you expect to the amount you need to invest. For instance, if a project requires an average investment of $50,000 and is expected to produce an average annual profit of $2,000, the ARR would be: 2,000 / 50,000 = 4%.

Advantages of using Accounting rate of return:

1) The main advantage is that it is easy to understand and calculate.

2) This is a simple capital budgeting technique and is widely used to provide a guide to how attractive an investment project is.

3) Another advantage is familiarity. The ARR concept is a familiar concept to return on investment (ROI), or return on capital employed.

The disadvantages of using Accounting rate of return:

1) This technique is based on profits rather than cash flow. Therefore it can be affected by non-cash items such as the depreciation and bad debts when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.

2) This technique does not adjust for the risk to longer term forecasts.

3) ARR does not take into account the time value of money.

4) This technique can be calculated in a wide variety of ways and hence lead to different outcomes.

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