Login

Average Accounting Return: Definition & Weaknesses

An error occurred trying to load this video.

Try refreshing the page, or contact customer support.

Coming up next: Internal Rate of Return: Advantages & Disadvantages

You're on a roll. Keep up the good work!

Take Quiz Watch Next Lesson
 Replay
Your next lesson will play in 10 seconds
  • 0:04 Average Accounting Return
  • 1:05 Calculating AAR
  • 2:31 Weaknesses of AAR
  • 3:25 Lesson Summary
Add to Add to Add to

Want to watch this again later?

Log in or sign up to add this lesson to a Custom Course.

Login or Sign up

Timeline
Autoplay
Autoplay
Create an account to start this course today
Try it free for 5 days!
Create An Account
Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson we will review how the average accounting return can be used to evaluate business investment options and identify some of its weaknesses as an evaluation tool.

Average Accounting Return

Kevin is an auto mechanic who owns his own successful shop. He has made so much money that he has a decision to make regarding growing his business: Should he expand his current shop or purchase a second location? It just so happens a friend of his is getting out of the business and is willing to sell the shop he owns. Kevin's ultimate goal is to get the best return on whatever money he invests back into the business. He decides to look at the numbers using the average accounting return so he can evaluate each deal, but he must also remain conscious of its weaknesses in this situation.

The average accounting return (AAR), also known as the accounting rate of return or simple rate of return, provides a ratio of the estimated profit to the amount of an investment. To solve for the AAR, Kevin needs to know his average profit and divide it by the average investment cost. The formula can be mathematically expressed as AAR = Average Profit / Average Investment.

Calculating AAR

Kevin has $200,000 available to invest in his business. He has estimated that it will cost $110,000 to build an additional bay onto his existing shop and $200,000 to buy the second shop from his friend. He projects that adding an extra bay will bring in an extra $25,000 in profit each year after his costs of construction and paying for enough tools and employees to keep the bay busy. His friend's shop consistently earns profits of $40,000 annually.

The AAR of the second bay looks like this:

$25,000 / $110,000 = .227

This gives the second bay an AAR of 22.7%.

The AAR of purchasing a second shop looks like this:

$40,000 / $200,000 = .200

The second shop has an AAR of 20.0%.

What does this mean to Kevin? Based on the above projections, using the average accounting return, adding a second bay to his current shop will generate an additional 2.7% in profit. Even though it earns less money compared to buying a second shop, the return on investment is higher for Kevin. He can also decide to set a minimum AAR threshold so that he can automatically dismiss any option that doesn't meet his minimum desired returns.

To unlock this lesson you must be a Study.com Member.
Create your account

Register for a free trial

Are you a student or a teacher?
I am a teacher
What is your educational goal?
 Back

Unlock Your Education

See for yourself why 10 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back

Earning College Credit

Did you know… We have over 95 college courses that prepare you to earn credit by exam that is accepted by over 2,000 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it free for 5 days!
Create An Account
Support