Two evaluation bases that include the concept of investment base in the analysis are ROI (return on investment) and RI (residual income).
Return on Investment (ROI)
A segment that has a large amount of assets usually earns more in an absolute sense than a segment that has a small amount of assets. Therefore, a firm cannot use absolute amounts of segmental income to compare the performance of different segments. To measure the relative effectiveness of segments, a company might use return on investment (ROI), which calculates the return (income) as a percentage of the assets employed (investment). The formula for ROI is:
|ROI =||Segment Income|
For example, a segment that earns $500,000 on an investment base of $5,000,000 has an ROI of 10% ($500,000 /$5,000,000). Return on investment is reported as a percentage. The return on investments means how much income do we generate for every dollar of investment. In this example, ROI was 10% which means the company earns 10 cents on every $1 of investment. To illustrate the difference between using absolute amounts and using percentages in evaluating a segment’s performance, consider the data in the table below for a company with three segments.
||Segment A||Segment B||Segment C||Total|
|Return on investment (a) ÷ (b)||10%||20%||25%||18.42%|
When using absolute dollars of income to evaluate performance, Segment B appears to be doing twice as well as Segment C. However, using ROI to evaluate the segments indicates that Segment C is really performing the best (25%), Segment B is next (20%), and Segment A is performing the worst (10%). Therefore, ROI is a more useful indicator of the relative performance of segments than absolute income.
This video will summarize the return on investment concept. Focus on the first 3 steps listed in the video.
Determining the investment base to be used in the ROI calculation is a tricky matter. Normally, the assets available for use by the division make up its investment base. But accountants disagree on whether depreciable assets should be included in the ROI calculation at original cost, original cost less accumulated depreciation, or current replacement cost. Original cost is the price paid to acquire the assets. Original cost less accumulated depreciation is the book value of the assets—the amount paid less total depreciation taken. Current replacement cost is the cost of replacing the present assets with similar assets in the same condition as those now in use. A different rate of return results from each of these measures. Therefore, management must select and agree on an appropriate measure of investment base prior to making ROI calculations or interdivision comparisons.
Each of the valuation bases has merits and drawbacks, as we discuss next. First, cost less accumulated depreciation is probably the most widely used valuation base and is easily determined. Because of the many types of depreciation methods, comparisons between segments or companies may be difficult. Also, as book value decreases, a constant income results in a steadily increasing ROI even though the segment’s performance is unchanged. Second, the use of original cost eliminates the problem of decreasing book value but has its own drawback. The cost of old assets is much less than an investment in new assets, so a segment with old assets can earn less than a segment with new assets and realize a higher ROI. Third, current replacement cost is difficult to use because replacement cost figures often are not available, but this base does eliminate some of the problems caused by the other two methods. Whichever valuation basis is adopted, all ROI calculations that are to be used for comparative purposes should be made consistently.
Although ROI appears to be a quite simple and straightforward computation, there are several alternative methods for making the calculation. These alternatives focus on what is meant by income and investment. The table below shows various definitions and applicable situations for each type of computation.
Definition of Income
Definition of Investment
|1. Evaluation of the earning power of the company. Do not use for segments or segment managers due to inclusion of non controllable expenses.||Net income of the company.*||Total assets of the company.†|
|2. Evaluation of rate of income contribution of segment. Do not use for segment managers due to inclusion of non controllable expenses.||Contribution to indirect expenses.||Assets directly used by and identified with the segment.|
|3. Evaluation of income performance of segment manager.||
Controllable income. Begin with contribution to indirect expenses and eliminate any revenues and direct expenses not under the control of the segment manager.
Assets under the control of the segment manager.
|* Often net operating income is used; this term is defined as income before interest and taxes.|
|† Operating assets are often used in the calculation. This definition excludes assets not used in normal operations.|
Even after the investment base is defined, problems may still remain because many segment managers have limited control over some of the items included in the investment base of their segment. For instance, top-level management often makes capital expenditure decisions for major store assets rather than allowing the segment managers to do so. Therefore, the segment manager may have little control over the store assets used by the segment. Another problem area may be the company’s centralized credit and collection department. The segment manager may have little or no control over the amount of accounts receivable included as segment assets because the manager cannot change the credit-granting or collection policies of the company.
Usually these problems are overcome when managers realize that if all segments are treated in the same manner, the inclusion of noncontrollable items in the investment base may have negligible effects. Then, comparisons of the ROI for all segments are based on a consistent treatment of items. To avoid adverse reactions or decreased motivation, segment managers must agree to this treatment.
Expanded form of ROI computation
The ROI formula breaks into two component parts:
The first part of the formula, Income/Sales, is called margin or return on sales. The margin refers to the percentage relationship of income or profits to sales. This percentage shows the number of cents of profit generated by each dollar of sales. The second part of the formula, Sales/Investment, is called turnover. Turnover shows the number of dollars of sales generated by each dollar of investment. Turnover measures how effectively each dollar of assets was used.
A manager can increase ROI in the following three ways.
When a company uses ROI to evaluate performance, managers have incentives to focus on the average returns from their segments’ assets. However, the company’s best interest is served if managers also focus on the marginal returns.
Residual income (RI) is defined as the amount of income a segment has in excess of the segment’s investment base times its cost of capital percentage. Each company based on debt costs establishes its cost of capital coverage and desired returns to stockholders. The formula for residual income (RI) is:
RI = Income − (Investment x Cost of capital percentage)
When a company uses RI to evaluate performance, the segment rated as the best is the segment with the greatest amount of RI rather than the one with the highest ROI.
Critics of the RI method complain that larger segments are likely to have the highest RI. In a given situation, it may be advisable to look at both ROI and RI in assessing performance or to scale RI for size.
A manager tends to make choices that improve the segment’s performance. The challenge is to select evaluation bases for segments that result in managers making choices that benefit the entire company. When performance is evaluated using RI, choices that improve a segment’s performance are more likely also to improve the entire company’s performance.
When calculating RI for a segment, the income and investment definitions are contribution to indirect expenses and assets directly used by and identified with the segment. When calculating RI for a manager of a segment, the income and investment definitions should be income controllable by the manager and assets under the control of the segment manager.
In evaluating the performance of a segment or a segment manager, comparisons should be made with (1) the current budget, (2) other segments or managers within the company, (3) past performance of that segment or manager, and (4) similar segments or managers in other companies. Consideration must be given to factors such as general economic conditions and market conditions for the product being produced. A superior segment in Company A may be considered superior because it is earning a return of 12%, which is above similar segments in other companies but below other segments in Company A. However, segments in Company A may be more profitable because of market conditions and the nature of the company’s products rather than because of the performance of the segment managers. Top management must use careful judgment whenever performance is evaluated.
To illustrate, assume the manager of Segment 3 below has an opportunity to take on a project involving an investment of $100,000 that is estimated to return $22,000, or 22%, on the investment with an income of $22,000. Since the segment’s ROI is currently 25%, or $250,000/$1,000,000, the manager may decide to reject the project because accepting the project will cause the segment’s ROI to decline. Suppose however, from the company’s point of view, all projects earning greater than a 10%return should be accepted, even if they are lower than a particular segment’s ROI.
Before acceptance of the project by Segment 3, the amounts are as follows:
|Segment 1||Segment 2||Segment 3|
|a. Income||$ 100,000||$ 500,000||$ 250,000|
|c. Cost of capital||10%||10%||10%|
|d. Desired minimum income (b) x (c)||$ 100,000||$ 250,000||$ 100,000|
|e. Residual Income (RI) [a - d]||-0-||250,000||150,000|
|c. Cost of capital||x 10%|
|d. Desired minimum income (b) x (c)||$ 110,000|
|e. Residual Income (RI) [a - d]||162,000|
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