The Return on Investment (ROI) Formula Return on investment (ROI) is defined as net operating income divided by average operating assets: Net operating income aa 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 actions 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 in terms of margin and turnover as follows: ROI = Margin X Turnover where . _ Net operating income Margin = Sales and Turnover = ee Average operating assetsElements of Return on Investment (RO!) operating operating ets.Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. In equation form, residual income is calculated as follows: Residual _ Net operating _ (Average operating .,- Minimum required income income assets rate of returnSegments Defined as Divisions Divisions Business Consumer Total Products Products Company Division Division SaNeS otra creeraye yale beret searersle arate neater $500,000 $300,000 $200,000 Variable expenses: Variable cost of goods sold. . Other variable expenses Total variable expenses . . Contribution margin ..... 180,000 120,000 60,000 50,000 30,000. 20,000 230,000 150,000 80,000 270,000 150,000 120,000 Traceable fixed expenses . ee 170,000 90,000. 80,000 — Divisional segment margin............. 100,000 $ 60,000 $ 40,000 Common fixed expenses not a a traceable to individual divisions ...... . 85,000 Net operating income..............++- $ 15,000For example, suppose that the Montvale Burger Grill expects the following operating results next month: Sales . $100,000 Operating expenses 3 $90,000 Net operating income .........2..... $10,000 ‘Average operating assets ............ $50,000 ‘The expected return on investment (ROI) for the month is computed as follows: Net operating income Sales jae Netoporiting income’, _Sales_ BOL Sales ‘Average operating assets _ $10,000, $100,000 $100,000 “ "$50,000 = 10% X 2 = 20% ‘Suppose that the manager of the Montvale Burger Grill is considering investing $2,000 in a state-of-the-art soft-serve ice cream machine that can dispense a number of different flavors. This new machine would boost sales by $4,000, but would require additional operating expenses of $1,000. Thus, net operating income would increase by $3,000, to $13,000. The new ROI would be: Net operating income Sales Sales ‘Average operating assets = $13,000 ,, $104,000 $104,000 “$52,000 = 12.5% X 2 = 25% (as compared to 20% originally) ROI=For purposes of illustration, consider the following data for an investment center— the Ketchikan Division of Alaskan Marine Services Corporation. Alaskan Marine Services Corporation Ketchikan Division Basic Data for Performance Evaluation ‘Average operating assets . ‘$100,000 Net operating income $20,000 Minimum required rate of return. 15% ‘Alaskan Marine Services Corporation has long had a policy of using ROI to evaluate its investment center managers, but it is considering switching to residual income. The con- troller of the company, who is in favor of the change to residual income, has provided the following table that shows how the performance of the division would be evaluated under each of the two methods: ‘Alaskan Marine Services Corporation Ketchikan Division Alternative Performance Measures Residual ROI Income $100,000 $100,000 $20,000 $20,000 20% Average operating assets (a) NA pera meaze() ROI, (b) = (a)....-- Minimum required return 05% x $1004 020 Residual income ....... ‘The reasoning underlying the residual income calculation is straightforward. The com- pany is able to eam a rate of retum of at least 15% on its investments. Because the ‘company has invested $100,000 in the Ketchikan Division in the form of operating assets, the company should be able to earn at least $15,000 (15% X $100,000) on this invest- ‘ment. Because the Ketchikan Division's net operating income is $20,000, the residual income above and beyond the minimum required return is $5,000. If residual income is adopted as the performance measure to replace ROI, the manager of the Ketchikan Division would be evaluated based on the growth in residual income from year to year.Alaskan Marine Services Corporation Ketchikan Division Performance Evaluated Using Residual Income Average operating assets Net operating income .. . . Minimum required return Residual income *$25,000 x 15% = $3,750. Present $100,000 $20,000 15,000 $ 5,000 New Project Overall $125,000 $24,500 18,750 $ 5,750