What it means
The appeal of AAR is that it speaks the language of the accounts. Managers are judged on reported profit and on return on assets, so a measure built from those same numbers tells them how a project will look on their own scorecard.
It is also easy to calculate from a budget that already exists. The calculation has two halves.
The numerator is average annual profit after depreciation and tax across the project's life, and the denominator is the average book value of the investment, usually the starting cost plus the ending value divided by two. Dividing one by the other gives a percentage that can be set against a target rate.
The weaknesses are real and worth stating out loud. AAR ignores the timing of money, so a dollar in year five counts the same as a dollar in year one, and it uses profit rather than cash, so depreciation choices move the answer.
Two projects with identical cash flows can report different average accounting returns purely because of how the assets are written down. In practice AAR works as a first filter or a secondary check.
A capital committee might screen proposals against a minimum AAR and then run discounted cash flow on the survivors, because net present value and internal rate of return answer the harder question of whether value is actually created. Quoting AAR on its own in a board paper tends to invite the question of what the discounted numbers say.
Watch two definitional traps. Some organisations use the initial investment rather than the average book value in the denominator, which roughly halves the reported return, and some use profit before tax.
Neither is wrong as long as the basis is stated and the same basis is used for every proposal being compared.
In practice
Real-world examples.
Example
A packaging manufacturer screens eleven capital requests against a 15% minimum average accounting return. Four proposals clear the bar and go forward for full discounted cash flow appraisal, and the rest are returned to sponsors with the numbers that failed. The screen takes an afternoon rather than a fortnight.
Example
A hotel group appraises a refurbishment of 60 rooms costing $1,800,000. Average budgeted profit after depreciation and tax is $162,000 and the average book value is $900,000, giving an AAR of 18%. The board approves the work but asks for the payback period as well, because the brand refresh is driven by a franchise deadline.
Example
A logistics business compares buying a fleet of vans with leasing them. The purchase shows a stronger average accounting return simply because leased vehicles never appear on the balance sheet, so the finance director insists both options are also compared on cash flows before any decision is taken.
Formula
Calculation
AAR = average annual profit after depreciation and tax divided by the average book value of the investment. A packaging firm is considering a $500,000 machine with a five-year life, written down in equal annual amounts to a zero residual value. Profit after depreciation and tax is budgeted at $60,000, $70,000, $50,000, $40,000 and $30,000, which totals $250,000, so average annual profit is $250,000 / 5 = $50,000. The average book value is the opening cost plus the closing value divided by two, which is ($500,000 + $0) / 2 = $250,000. The AAR is therefore $50,000 / $250,000 = 20%, comfortably above the committee's 15% minimum, so the proposal moves on to a discounted cash flow review.Case study
Seen in the real world.
Marrow Lane Foods is a fictional ready-meals business used here for illustration. Its capital committee had two proposals for identical production lines, each costing $400,000 and each generating the same cash flows over five years.
One sponsor had used equal annual depreciation and the other had used an accelerated method that charged more in the early years. The second proposal reported lower profit early on, and because the committee looked only at the average accounting return it ranked the first proposal higher, even though the cash flows were the same.
The illustrative fix was a one-line rule in the capital policy, which was that every proposal uses the same depreciation basis and the same definition of average book value, and that no proposal is approved on AAR alone without a net present value figure beside it.
Watch out
Common mistakes.
- Using the initial cost rather than the average book value as the denominator, which halves the reported return and makes projects look worse than the comparison set.
- Comparing two proposals that use different depreciation methods, so the ranking reflects accounting policy instead of economics.
- Treating AAR as a substitute for discounted cash flow, when it ignores the timing of money altogether.
Questions
People also ask.
Is AAR the same as return on investment?
They are close cousins, but AAR has a specific definition built on average accounting profit and average book value, while return on investment is used far more loosely.
Why does AAR still get used?
Because it is quick, it draws on budget numbers that already exist, and it shows how a project will look in the reported results managers are measured on.
What should sit alongside it?
Net present value, internal rate of return and payback period, so the committee sees value creation, return and risk of delay together.
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