Return on Investment (ROI) Method for Measuring Managerial Performance:
In a truly decentralized company,
segment managers are given a great deal of autonomy.
Profit and investment centers are
virtually independent businesses, with their managers having about the
same control over decisions as if they were in fact running their own
independent firms. With this autonomy, fierce competition often develops
among managers, with each striving to make his or her segment the "best"
in the company.
Competition between investment centers is particularly keen
for investment funds. How do managers in corporate headquarters go
about deciding who gets new investment funds as they become available and
how do these managers decide which investment centers are most
profitability using the funds that have already been entrusted to their
care? One of the most important ways of making these judgments is
to measure the rate of return that investment managers are able to
generate on their assets. This rate of return is called the return on
investment (ROI).
Definition of Return on Investment (ROI):
The return on investment (ROI) is defined as net operating income
divided by average operating assets.
ROI Formula / Equation:
[ROI = Net operating income / Average operating assets]
Net
operating income and operating assets defined:
Net operating income rather than net income is used in the ROI
formula. Net operating income is income before interest and taxes and is
sometimes referred to as "earnings before interest and tax (EBIT)" Net
operating income is used in the formula because the base (i.e..,
denominator) consists of operating assets. Thus, to be consistent
we use net operating income in the numerator. Operating assets include
cash, accounts receivable, inventory, plant and equipment, and all other
assets held for productive use in the organization. Examples of
assets that would not be included in operating assets category would
include land held for future use, an investment in another company, or a
building rented to someone else. These are also called non operating
assets.
The operating assets used in the formula is typically computed as the
average of the operating assets between the beginning and the end of the
year.
Plant and Equipment: Net Book Value or Gross Cost?
Determining the dollar amount of plant and equipment that should be
included in the operating assets base is a major issue in ROI
computations.
Example:
Assume that a company reports the
following amounts for plant and equipment on its balance sheet:
| Plant and
equipment |
$3,000,000 |
| Less
accumulated depreciation |
900,000 |
| |
|
| Net book
value |
$2,100,000 |
| |
|
What dollar amount of plan and equipment should company
include in its operating assets in computing ROI?
One widely used
approach is to include only the plant and equipment's net book value.
That is the plant's original costless accumulated depreciation
($2,100,000 in the example above). A second
approach is to ignore depreciation and include the plant's entire gross
cost in the operating assets base ($3,000,000 in the example above). Both of these approaches are used in
actual practice, even though they will obviously yield very different
figures for operating assets and therefore for RIO computations.
The following arguments can be raised
for using net book value to measure operating assets and for using gross
cost to measure operating assets in ROI computations:
Arguments for using net book value to measure operating assets in ROI
computation:
- The net book value method is consistent with how plant and
equipment are reported on the balance sheet (cost less accumulated
depreciation)
- The net book value method is consistent with the computation of
operating income, which includes depreciation as an operating expenses.
Arguments for using gross operating assets in ROI computations:
- The gross cost method eliminates both the age of equipment and the
method of depreciation as factors in ROI computations. Under net book
value method ROI will tend to increase over time as net book value
declines due to depreciation.
- The gross cost method does not discourage replacement of old ,
worn-out equipment. Under net book value method, replacing fully
depreciated equipment with new equipment can have a dramatic, adverse
effect on return on investment (ROI).
Managers generally view consistency as the most important
consideration. As a result, a majority of companies use the net book
value approach in ROI computations.
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