Return on Investment: Formula, Evaluation, Criticisms

Return on Investment

Evaluating an investment center’s performance requires more than accurate cost and segment margin reporting. Also, an investment center is responsible for earning an adequate return on investment.

The Return on Investment (ROI) Formula

Return on investment (ROI) is defined as net operating income divided by average operating assets:

ROI = Net operating income / Average operating assets

The higher a business segment’s return on investment (ROI), the greater the profit earned per dollar invested in the segment’s operating assets.

Understanding ROI

The equation for ROI, net operating income divided by average operating assets, does not provide much help to managers interested in taking action to improve their ROI. It only offers two levers for improving performance—net operating income and average operating assets.

Fortunately, ROI can also be expressed as follows:

ROI = Margin x Turnover

where;

  • Margin = Net operating income / Sales and
  • Turnover = Sales / Average operating assets

Note that the terms of the sale in the margin and turnover formulas cancel out when they are multiplied together, yielding the original formula for ROI stated in terms of net operating income and average operating assets.

So, either formula for ROI will give the same answer.

However, the margin and turnover formulation provides some additional insights. From a manager’s perspective, margin and turnover are very important concepts.

Margin is ordinarily improved by increasing sales or reducing operating expenses, including the cost of goods sold and selling and administrative expenses.

The lower the operating expenses per dollar of sales, the higher the margin earned. Some managers tend to focus too much on margin and ignore turnover.

However, turnover incorporates a crucial area of a manager’s responsibility—the investment in operating assets.

Excessive funds tied up in operating assets (e.g., cash, accounts receivable, inventories, plant and equipment, and other assets) depress turnover and lower ROI.

Inefficient use of operating assets can be just as much of a drag on profitability as excessive operating expenses, which depress margin.

E.I. du Pont de Nemours and Company (better known as DuPont 1) pioneered the use of ROI. They recognized the importance of looking at both margin and turnover in assessing a manager’s performance. ROI is now widely used as the key measure of investment center performance.

ROI reflects in a single figure many aspects of the manager’s responsibilities.

It can be compared to the returns of other investment centers in the organization, the returns of other companies in the industry, and to the past returns of the investment center itself.

This exhibit helps managers understand how they can improve ROI. Any increase in ROI must involve at least one of the following:

  1. Increased sales
  2. Reduced operating expenses
  3. Reduced operating assets

Many actions involve combinations of changes in sales, expenses, and operating assets.

For example, a manager may invest (i.e., increase) operating assets to reduce operating expenses or increase sales. Whether the net effect is favorable or not is judged in terms of its overall impact on ROI.

Criticisms of ROI

Although ROI is widely used in evaluating performance, it is subject to the following criticisms:

  1. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company’s strategy or they may take actions that increase ROI in the short run but harm the company in the long run (such as cutting back on research and development). This is why ROI is best used as part of a balanced scorecard. A balanced scorecard can provide concrete guidance to managers, making it more likely that their actions are consistent with the company’s strategy and reducing the likelihood that they will boost short-run performance at the expense of long-term performance.
  2. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. These committed costs may be relevant in assessing the performance of the business segment as an investment, but they make it difficult to fairly assess the performance of the manager.
  3. As discussed in the next section, a manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company, but that would harm the manager’s performance evaluation.

Conclusion

The first method, covered in this section, is called return on investment (ROI). The second method, covered in the next section, is called residual income.