ROI deals with the money you invest in the company and the return you realize on that money based on the net profit of the business. Profit, on the other hand, measures the performance of the business.
Return on investment (ROI) is a ratio between net profit (over a period) and cost of investment (resulting from an investment of some resources at a point in time). A high ROI means the investment’s gains compare favorably to its cost.
There is, however, a serious problem with using net book value. This problem results because the investment base of a division will be automatically reduced as the asset ages. Thus the rate of return will increase simply by the passage of time.
This normalizes the returns so a business can compare two different investments that have different costs. For example, if a company has an investment that costs $10 and returned $5 and another investment that cost $1,000 and returned $100, even though the $1,000 investment earned more money, the $10 has a better return. To do this, however, would take drastic changes in the division’s accounting procedures, which most companies seem reluctant to make. Furthermore, I question what would be gained over controlling investment and profits separately.
Developments in ROI
As a result of these changes, the ROI earned by a division differs widely from the returns projected in the investment proposals even when actual profits are the same as projected. Let us take the previous example and assume that the company uses the time-adjusted rate of return method for making capital expenditure decisions and the sum-of-the-year’s digits for depreciating fixed assets. Thus, the major focus of ROI is on the required level of investment.
This allows them to choose an investment that will enhance both divisional and organisational profit performance as well as enable effective utilisation of existing investments. Although the residual income method is much better than the investment-return approach, it still does not solve one of the basic problems with ROI control. Fixed assets must still be included in the investment base at some value, and the problem of which value to use still exists. If gross book value is used, residual income can be increased by scrapping or replacing assets, regardless of the economic impact to the company.
Marketers should understand the position of their company and the returns expected. In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the “return on investment” metric very useful.
How to Calculate ROI
Only in sole proprietorships does equity equal the total investment or assets of the business. The return on investment shows how much a company made on a particular investment as a percentage.
How to Calculate ROI on a Rental Property
As you can see in this exhibit, there is little resemblance between the return rate on which the investment decision was based and the ROI earned by the division. This is a serious limitation to the use of ROI for management control.
- Consequently, we should stop evaluating division performance on the basis of a ratio (profit divided by investment) or by charging management with a cost for the fixed assets being used.
ROI – Return on Investment
This situation is aggravated further when a company uses some form of accelerated depreciation (as most large companies do). The amount of depreciation becomes smaller as the assets become older. Thus, new investments are discouraged because they will reduce a division’s ROI, at least in the short run. The use of some form of return on investment (ROI) as a management control device in evaluating the profit performance of division managers has been widely adopted in many decentralized companies.
For a given business unit at a given point of time, there is an optimum level of investment in each asset that helps maximise earnings. A cost-benefit analysis of this kind helps managers find out the rate of return that can be expected from different investment proposals.
As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In economic terms, it is one way of relating profits to capital invested.
At the same time, the attempt to control profit and investment by a single ratio results in all of the problems that I described earlier. Most progressive companies are using some form of discounted cash flow to make investment decisions and some form of accelerated depreciation to write off assets.
Yet the evidence shows that this control system has serious limitations, which result from the inability to use ROI to make correct evaluations. The author notes that any criticism of the use of ROI is met with the response, “I agree it is not perfect, but it is the best system available.” This, he says, is the crux of the problem. He believes there are better systems available and offers specific actions that should improve the management control system of any company using ROI measurement. Marketing decisions have an obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets’ usage and capital requirements (for example, receivables and inventories).
If net book value is used, residual income will increase automatically through the passage of time. Furthermore, new investments, with a satisfactory average rate of profit, will often reduce the residual income of a division in the early years. Residual income, therefore, is no better than ROI as a method of controlling investments in fixed assets. The pattern of this return would be from a low to a high return and, as I explained earlier, this is not really satisfactory for management control because it might discourage investments that would not earn an immediate payback. Over the entire period, however, the average return would be consistent with the capital investment decisions and any deviations from the capital investment estimates would be reflected in the division’s performance.
Many division managers will be reluctant to propose capital investments that do not have a rapid early payback, especially those who expect to be moved to another job within a few years. Over the entire period, however, a division manager could miss the projections on which the capital investment decision was based by a large percentage and still earn the ROI projected.
What does a return on investment mean?
ROI (Return on Investment) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company’s profitability or to compare the efficiency of different investments.
Consequently, we should stop evaluating division performance on the basis of a ratio (profit divided by investment) or by charging management with a cost for the fixed assets being used. The division manager’s profit performance should be based on the amount of profits he has earned compared to some type of objective. Fixed assets should be controlled by capital investment analysis procedures and post-completion audits. It seems to me that a company has everything to gain and nothing to lose in controlling these two separately. ROI does not provide any control and only obscures the fact that there is no real control.