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Managerial Accounting/Performance Measures/Return on Investment (ROI)

Performance Measures

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Return on Investment (ROI)

Return on Investment in Cost Accounting

Cost accounting helps organizations make informed decisions about the return on the investment of resources.

Return on investment (ROI) as it relates to cost accounting measures the profit generated using the operating assets of a business as a formula-derived ratio. ROI is one of the most frequently used performance measurements in the corporate world. By measuring ROI, managers can view profitability in relation to the size of the investment. This information can help the company determine if the investment is the best use of the corporation's money or if it would be better to invest in something else.

ROI is commonly calculated by dividing net operating income into average operating assets.
ReturnonInvestment=NetOperatingIncomeAverageOperatingAssets\text{Return}\;\text{on}\;\text{Investment}=\frac{\text{Net}\;\text{Operating}\;\text{Income}}{\text{Average}\;\text{Operating}\;\text{Assets}}
Net operating income is the amount of profit left after deducting all expenses but before accounting for interest and taxes. Operating assets are cash, accounts receivable, inventory, buildings and equipment, and all other items a business owns that are used to run the business. Operating assets can include cash, accounts receivable, inventory, factories, and equipment. However, operating assets do not include items used for investment or other purposes.

ROI can also be broken down in terms of margin and turnover. Margin is the profit from the sale of a good minus all of the expenses of selling and manufacturing the good, expressed as a dollar figure or percentage. Investment turnover is the measure of a company's sales divided by the invested capital. Managers use turnover to determine how effective the asset is in generating sales.

Managers often express ROI in terms of margin and turnover.
ReturnonInvestment=Margin×Asset Turnover\text{Return}\;\text{on}\;\text{Investment}=\text{Margin}\times\text{Asset}\ \text{Turnover}
AssetTurnover=SalesAverageOperatingAssets\text{Asset}\;\text{Turnover}=\frac{\text{Sales}}{\text{Average}\;\text{Operating}\;\text{Assets}}
Examining ROI in terms of margin and turnover can help a manager determine how to increase ROI. It's possible to increase margin by selling the goods at a higher price or by reducing the expense of producing the goods. Increasing the number of goods sold can also affect the bottom line by producing more positive income. Margin, turnover, assets, and expenses are often areas that are under a manager's control. However, the type of business affects what managers focus on to improve ROI. For example, a low-sales-volume business such as a car dealership may only sell a few cars per day. Therefore, the manager of a car dealership relies on margin more than turnover to generate a positive ROI. A car dealership manager would most likely find it easier to reduce costs, raise prices, or make other margin adjustments to improve ROI for selling cars than it would be to try to double the number of cars sold per day. On the other hand, a local grocery store might sell thousands of items per day, generating a small profit on every (or nearly every) item sold. A manager of a grocery store then may choose to focus on increasing turnover and the number of items sold per day to increase ROI rather than doubling the prices of all the grocery store items overnight. Another factor that can affect margin and turnover considerations is spoilage. Some products, such as groceries, spoil quickly. For this reason, it makes sense to sell those products quickly and at relatively low margins.

Return on Investment Formula

Calculation of ROI shows profitability expressed as a percentage of invested assets. Regardless of highest income, it is usually better to invest more heavily in whichever product or service makes the highest ROI percentage.

Return on Investment as a Performance Measure

Businesses can use ROI to help determine how effective a manager of an investment center is.

Evaluating ROI can be an important part of measuring how effective a manager of an investment center is within a business. Managers have many responsibilities and many different ways that they can affect costs and expenses in relation to the assets they manage. ROI provides a way to distill these many responsibilities down into a single number that can then be compared to the returns of the investment center itself previously, the returns of managers of other investment centers within the same organization, or the returns of similar companies within the same industry.

While ROI is an important performance measurement, a company may not want to rely on it as the only method to evaluate an investment center's management performance. Telling a manager to increase ROI at all costs may not work if the manager does not know how to increase ROI effectively. Also, the manager may act to increase ROI in ways that run contrary to the company's overall corporate strategy. For example, a manager may increase ROI in the short term by cutting back on future-focused costs, such as research and development. Such action would likely reduce long-term ROI because the company would fall behind its competitors' product offerings. This situation depends on whether competitors continue to invest in research and development and whether they do so at a higher level than the manager's company does.

Managers also may have committed costs within their investment center that they have no control over because of choices made by prior managers or because of overall corporate strategy. This may limit the ways in which they can act to improve ROI, or it may make their current ROI numbers look comparatively weaker than they truly are. For instance, if a previous manager tried to trim expenses by buying outdated or inferior raw materials, then the current manager may have some hard decisions to make. The company may lower its prices on certain items or sell off those raw materials in an attempt to get back on track again.

Finally, managers may feel pressure to pursue opportunities that benefit the ROI of their investment center but have a negative impact on the ROI for the company as a whole. For example, a company may have two divisions that produce complementary products, such as a home water softener systems division and a water coolers and bottled water division. The manager of the home water softener systems division may decide to start selling residential home water filters that will allow customers to filter their own tap water and eliminate the need for them to buy water coolers and bottled water. This action may increase the ROI of the home water softener system division. However, it will reduce the ROI for the company overall because it will lessen sales of water coolers and bottled water, therefore harming the ROI of that division.

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