Return on Investment (ROI) - Explained
What is a ROI?
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What is Return on Investment?
Return on investment (ROI) is a profitability ratio used for measuring the amount of profit generated by an investment relative to its cost. It evaluates the cost efficiency of an investment and is expressed as a percentage or ratio.
How to Calculate ROI?
It is calculated as the return of an investment divided by the cost of the investment. The formula for computing the ROI is,
ROI = Profit Margin / Cost of Investment
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
The gain on investment is the increase in value of an asset. The gain on investment minus the cost of investment is known as the profit margin.
If the investment is in products to be sold (rather than a single asset), then you will need to know the total quantity of goods purchased for sale and the total sales volume. This is important, as the cost of investment will include all products purchased. Your profit margin will be determined based upon how many items you sell.
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Using ROI to Evaluate Performance of an Investment Center
If you are using ROI to evaluate the performance of an investment center in a company, you may see the equation as:
Return on investment = Operating income / Average operating assets
This measure provides an assessment of how effectively each division is using operating assets to produce operating income.
ROI can also be broken into two separate ratios, operating profit margin and asset turnover, which are multiplied together to get ROI as follows:
Return on Investment = Operating income / Average operating assets
Operating profit margin = Operating Income / Sales
Asset turnover = Sales Average / Operating Assets
Many variations of the ROI calculation are used in practice depending on the nature of the organization.
Operating income is the income produced by the division from its daily activities.
It excludes items used in the calculation of net income, such as income tax expense, interest income, interest expense, and any unusual gains or losses.
The focus is on how well the division performed relative to its core business operations, which does not include one-time gains or losses from the sale of property, plant, and equipment for example.
Average operating assets are the assets that the division has in place to run the daily operations of the business, and this value is calculated by adding beginning period balances and ending period balances and dividing by two.
Examples of operating assets include cash, accounts receivable, prepaid assets, buildings, and equipment.
As long as the division uses the assets to produce operating income, they are included in the operating assets category.
Examples of non-operating assets—assets not included in this calculation—include land held for investment purposes and office buildings leased to other companies.
An average of operating assets is taken over the period being evaluated for two reasons.
First, operating assets are often purchased and sold during an accounting period, and simply taking the ending balance might produce distorted, if not inaccurate, results.
Second, operating income represents information for a period of time (income statements always present information for a period of time), while operating assets are presented at a point in time (balance sheets always present information for a point in time).
If both of these items are to be included in one ratio (ROI), it is best to use average balance information for balance sheet items.
In fact, if the information is readily available, it would be best to take an average of daily operating asset balances for the period being evaluated.
Organizations often create their own unique calculation of operating income for internal evaluation purposes.
There are several variations that organizations use when calculating operating income.
Excluding Allocated Overhead from ROI Calculation
The segmented income statements - Notice the expense line item labeled allocated overhead (from corporate).
Although we include this expense in calculating operating income, many organizations do not, particularly if division managers have no control over allocated overhead.
Excluding allocated overhead has the effect of increasing ROI for each division manager and holds each division manager responsible only for expense amounts that are controllable.
Including Income Tax Expense from ROI Calculation
Although we do not include income tax expense in the operating income calculation, some organizations prefer to include this item.
Including after-tax expense reduces ROI for each division manager (assuming each division is profitable).
The point here is that the needs of management determine how to define operating income.
Average Operating Assets Calculation
The average is found by taking the beginning balance plus ending balance and dividing by two. The issue in this calculation focuses on long-term assets that are depreciated over time.
There are two common approaches to valuing long-term assets when calculating ROI.
Using Net Book Value to Calculate ROI
The net book value of long-term assets to calculate operating assets.
That is, accumulated depreciation is subtracted from the original cost on the segmented balance sheet in accordance with U.S. GAAP.
The advantage of using net book value is that the information is easily obtained from the financial records.
The problem with this approach is division managers with older assets that have been substantially depreciated have an advantage over division managers with newer assets that have not been significantly depreciated.
Older assets have a lower net book value (cost – accumulated depreciation) than newer assets, which reduces average operating assets in the denominator and increases ROI.
Assuming all other assets are identical, and both divisions have identical operating income, Division 1 will have a higher ROI simply because long-term assets are older and have more accumulated depreciation, thereby reducing average operating assets in the denominator. (Reducing the denominator increases the ratio.)
An additional weakness in using net book value to calculate average operating assets is the disincentive it creates for division managers to replace old and inefficient long-term assets, such as equipment and machinery.
Although new equipment purchases may be needed to improve efficiency and to remain competitive, the short-term impact is to reduce ROI.
If division managers are evaluated based on ROI, using net book value tends to discourage investments in long-term assets, often at the expense of the organization’s long-term profitability.
Using Gross Book Value to Calculate ROI
An alternative approach in calculating ROI is to use gross book value in the average operating assets calculation.
Gross book value simply refers to the original cost of long-term assets and ignores accumulated depreciation.
In our example of two divisions with identical assets and identical operating income, the same original cost amount is used in calculating average operating assets.
Division 2 is not penalized in the denominator for having newer assets and less accumulated depreciation.
Example of Return on Investment
For example, if an individual invests $1000 for 100 units ($10 per unit) of inventory. After a year, he or she sells the inventory at retail for $15 each of $1500 if all are sold. Then the profit margin is $5 per unit ($15 - $10 = 5) above the value of the initial cost or investment. Thus, the return on investment is $5/$10=0.5 or 50% per unit. To calculate the ROI for the entire investment, you will need to know the sale volume.
If you sell all of the product, your RIO is 50%. If you sell less than the entire amount of inventory, the ROI will be less. For example, if you sell 90 units, the gain on investment is $1350 (90 x $15 = $1350). The ROI is then 350/1000 = .35 or 35%.
How is Return on Investment Used?
ROI is used for comparing returns from various investments that allow the investor to invest their capital efficiently. It is the most common indicator used across different types of investments. It is easy to calculate the ROI because of its simplistic nature; although, for companies it is a bit more complicated when there are several inputs. The investors compare the ROI of different investments and it is always better to go for a higher ROI. Negative ROI depicts a loss, so those investments should be avoided. ROI allows the investors to make an informed decision when investing their money. It is important for investors to use the same inputs for calculating ROI while comparing different investments. One shortcoming of comparing ROIs of similar project is it doesn't take time into consideration.
Suppose, an individual invests $2,000 to buy stocks of a company. One year later he sells it at $2400. The profit from the investment is ($2,400-$2000) = $400 and ROI is $400/$2000= 0.2 or 20%. Then the same individual buys stocks of a company with $4000 and sells those shares in the market 3 years later at $4800. His profit from the investment is ($4800-$4000) = $800 and the return on investment is $800/$4000=0.2 or 20%. So apparently the ROI is the same for both the investments, but in the first case it took only one year and in the second instance it took three years. So, the first investment is more profitable than the second one although the ROI is the same for both.
Thus, ROI provides a simplistic estimate of the profitability of an investment. As such, other indicators must also be taken into account when comparing different investments. The Rate of Return or Net Present Value can be used along with ROI to get a more accurate estimate.
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