Return on Investment (ROI)

Return on Investment (ROI) is a divisional performance measure used for investment centres.

Calculation

ROI is a similar measure to ROCE but is used to appraise the investment decisions of an individual department.

• Controllable profit is usually taken after depreciation but before tax. 
• Capital employed is total assets less long term liabilities or total equity plus long term debt. 
• Non-current assets might be valued at cost, net replacement cost or net book value (NBV). The value of assets employed could be either an average value for the period as a whole or a value as at the end of the period. An average value for the period is preferable.

Illustration

Division A of Babbage Group had investments at the year end of $56 million. These include the cost of a new equipment item costing $3 million that was acquired two weeks before the end of the year. This equipment was paid for by the central treasury department of Babbage,and is recorded in the accounts as an inter-company loan.

The profit of division A for the year was $7 million before deducting head office recharges of $800,000.

Required:

What is the most appropriate measure of ROI for Division A for the year?

Solution

Since the new equipment was bought just two weeks before the year end, the most appropriate figure for capital employed is $53 million,not $56 million.

The figure for profit should be the controllable profit of $7 million.

ROI = $7 million/$53 million = 13.2%

Evaluation of ROI as a performance measure

ROI is a popular measure for divisional performance but has some serious failings which must be considered when interpreting results.

Advantages

• It is widely used and accepted since it is line with ROCE which is frequently used to assess overall business performance.
• As a relative measure it enables comparisons to be made with divisions or companies of different sizes.
• It can be broken down into secondary ratios for more detailed analysis, i.e. profit margin and asset turnover.

Disadvantages

• It may lead to dysfunctional decision making, e.g. a division with a current ROI of 30% would not wish to accept a project offering a ROI of 25%, as this would dilute its current figure. However, the 25% ROI may meet or exceed the company's target.
• ROI increases with the age of the asset if NBVs are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent machines.
• It may encourage the manipulation of profit and capital employed figures to improve results, e.g. in order to obtain a bonus payment.
• Different accounting policies can confuse comparisons (e.g. depreciation policy).

Dysfunctional decision making

Where ROI is used as a performance measure - management may only take decisions which will increase divisional ROI, regardless of wider corporate benefits.

Illustration

Managers within MV plc are appraised on the ROI of their division. The company's cost of capital is 15%.

Jon, a divisional manager, has the following results:

Within his division, the purchase of a new piece of equipment has been proposed. This equipment would cost $20,000, would yield an extra $4,000 of profit and would have many other non-financial and environmental benefits to the division and the company as a whole.

Required:

Will Jon invest in the new equipment? Is this the correct decision for the company?

Solution:

• Jon's decision - from a personal point of view, the ROI of Jon's division will go down and his bonus will be reduced or lost as a result. Therefore, Jon will reject the investment.
• However, the new equipment has a ROI of 20%. This is higher than the company's cost of capital (required return) of 15% and therefore Jon should accept the new investment.

The problem of ageing assets

The ROI will increase with the age of the asset. This may encourage divisional managers to hold onto old, and potentially inefficient assets, rather than investing in new ones.

Illustration

McKinnon Co sets up a new division in Blair Atholl investing $800,000 in non-current assets with an anticipated useful life of 10 years and no scrap value. Annual profits before depreciation are expected to be a steady $200,000.

Required

You are required to calculate the division's ROI for its first three years based on the opening book value of assets. Comment on your results.

Solution

ROI = (Earnings before interest and tax (but after depreciation))/(Capital employed (book value at start of year)) × 100%

The ROI increases, despite no increase in annual profits, merely as a result of the book value of assets falling. Therefore, the divisional manager will be rewarded for holding onto old, and potentially inefficient, assets.

Comparing divisional performance

Divisional performance can be compared in many ways. ROI and RI are common methods but other methods could be used.

• Variance analysis is a standard means of monitoring and controlling performance. Care must be taken in identifying the controllability of, and responsibility for, each variance.
• Ratio analysis - there are several profitability and liquidity measures that can be applied to divisional performance reports.
• Other management ratios - this could include measures such as sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour.
• Other information such as staff turnover, market share, new customers gained, innovative products or services developed.

Further topics

The most common alternative to ROI is to use residual income (RI)) instead.

One way of trying to solve the problem of dysfunctional decision making, especially with ageing assets is to use annuity depreciation.

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Tags:	return on investment;ROI;divisional performance management;Divisional Performance