Review of Industrial Organization 17: 457–463, 2000.
© 2000 Kluwer Academic Publishers. Printed in the Netherlands.
Measuring the Economic Rate of Return on Assets
J. K. KAPLER
Department of Economics, University of Massachusetts at Boston, 100 Morrissey Boulevard,
Boston, MA 02125-3393, U.S.A.
Abstract. This paper (1) describes a procedure for correcting the deﬁciencies associated with the
accounting rate of return, and for capitalizing the intangible assets created by the ﬁrm’s R&D ex-
penditures; and (2) demonstrates the superiority of the derived measure of rate of return in a ﬁxed
effects model testing the relative inﬂuence of ﬁrm and industry effects on returns. Both of these
inﬂuences are shown to be much stronger than in previous empirical work.
Key words: Accounting rate of return, economic rate of return, ﬁrm ﬁxed effects, industry ﬁxed
Research on the structure of industries and on the nature of intra- and inter-industry
competition requires a measure of the ﬁrm’s rate of return on assets for hypothesis
testing or descriptive analysis. There is general agreement in the literature that the
accounting rate of return (ARR)
is unsatisfactory for this purpose (Geroski, 1998;
Mueller, 1990; Schmalensee, 1985; Kapler, 1997), although the seeming lack of
available alternatives resigns practitioners to the use of this measure (Schmalensee,
1985; Gort and Singamsetti, 1976; Wernerfelt and Montgomery, 1986; Cubbin and
Geroski, 1987; Mueller, 1977; Scott and Pascoe, 1986).
The deﬁciencies of the ARR with respect to the treatment of interest expense,
depreciation, R&D, and the valuation of ﬁxed assets are well-known (Schmalensee,
1985; Fisher and McGowan, 1983, p. 82). This paper (1) describes a procedure for
correcting the deﬁciencies associated with ARR, and for capitalizing the intangible
assets created by the ﬁrm’s R&D expenditures; and (2) demonstrates the superi-
ority of this procedure with a simple ﬁxed-effects model to explain the relative
contributions to ﬁrm performance from ﬁxed ﬁrm and industry effects.
The accounting rate of return is the ratio of pre-tax or post-tax income to assets measured at the
historic acquisition cost (or “book value”) (Fisher and McGowan 1983, p. 83, n. 6).