Return on Investment (ROI)
ROI defined as a measure of profit divided by a measure of investment in the business unit
→ The higher the percentage, the better the indicated financial performance
→ typically defined as divisional operating income.
→ The achieved level of ROI depends on several factors:
○ General economic conditions
○ Company's current economic conditions
Evolution of ROI formula
1.
→ How well each investment center used its
invested capital to earn a profit
2.
3.
→ Two components in ROI (DuPont approach):
▪ ROS: profit per sales dollar
> measures the manager’s ability to
control expenses and increase
revenues to improve profitability
▪ AT: the amount of sales dollars generated
per dollar of investment
> measures the manager’s ability to
increase sales from a given level of
investment.
→ The 2 components of ROI provide managers with
new insight so that they can provide an enhance
evaluation and comparison between different
units in the org.
Measurement Issue
1. Depreciation policy: The UL of assets and depn
method affect both income and investment
→ larger depreciation charges reduce ROI
2. Capitalisation policy: Either item is capitalised or
expensed as an asset;
→ an expensed item reduces the numerator of ROI,
a capitalized item reduces the denominator
3. For inventory:
a. Inventory measurement methods
▪ choice of inventory cost-flow assumption
(FIFO, LIFO) affects “income” and reported
inventory values (the denominator,
“investment” could be affected by this
choice) (e.g. LIFO increases CGS and
decreases inventory in times of rising
prices causing ROI to decrease)
b. Full costing
→ Creates an upward bias on income, and
thus on ROI, when inventory levels are ↑;
the reverse is true when inventory levels
are falling
c. Disposition of variances
→ standard cost variances can be closed to
the CGS account or prorated to CGS and
ending inventory accounts; the choice has
a direct effect on income and inventory bal
ACT4132 [MA 3] Page 1
Improving ROI
2 ways to improve ROI:
1. Increase sales revenue
2. Reduce business unit's invested capital
a. Reduce inventories - may have diverse effect
b. Sell PPE or other NCA
The advantage s of ROI
• Encourage mangers to focus on both profit and
asset to generate those profit
○ Manager to consider relationship between the
2
○ Focus on increase revenue and reduce cost
○ Discourage excessive investment in assets - if
merely focus on profit
• Evaluate relative performance of Investment
centres
○ Even when different units have different
scales
• Easily understood by managers & widely used
The limitations/deficiencies of ROI
• Goal congruence issue
○ incentive for high ROI units to invest in
projects with ROI higher than the minimum
rate of return but lower than the unit’s
current ROI
• Encourage managers to focus on short term
financial performance, at the expense of long term
○ Excessive cost cutting may improve profit but
weaken future profits and business future
competitiveness
○ Managers will do anything necessary for their
own interests
• Discourage managers from investing in projects
(goal congruence problem)
○ Where the project decreases the unit's ROI
Minimising the behavorial problems of ROI
• Use ROI only ad part or series of performance
measure that focusses on both long and short term
performance
• Consider other alternative ways of measuring
invested capital - so that replacement of asset will
less likely to reduce ROI
• Using alternative financial measures as well - RI and
EVA