# Average Accounting Return: Definition & Weaknesses

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• 0:04 Average Accounting Return
• 1:05 Calculating AAR
• 2:31 Weaknesses of AAR
• 3:25 Lesson Summary
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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.

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