The Return on Investment (ROI) Formula
Return on investment (ROI) is defined as net operating income divided by average
operating assets:
Net operating income
aa Average operating assets
The higher a business segment’s return on investment (ROI), the greater the profit earned
per dollar invested in the segment’s operating assets.Understanding ROI
The equation for ROI, net operating income divided by average operating assets, does not
provide much help to managers interested in taking actions to improve their ROI. It only
offers two levers for improving performance—net operating income and average operating
assets. Fortunately, ROI can also be expressed in terms of margin and turnover as follows:
ROI = Margin X Turnover
where
. _ Net operating income
Margin = Sales
and
Turnover = ee
Average operating assetsElements of Return on Investment (RO!)
operating
operating
ets.Residual income is the net operating income that an investment center earns above the
minimum required return on its operating assets. In equation form, residual income is
calculated as follows:
Residual _ Net operating _ (Average operating .,- Minimum required
income income assets rate of returnSegments Defined as Divisions
Divisions
Business Consumer
Total Products Products
Company Division Division
SaNeS otra creeraye yale beret searersle arate neater $500,000 $300,000 $200,000
Variable expenses:
Variable cost of goods sold. .
Other variable expenses
Total variable expenses . .
Contribution margin .....
180,000 120,000 60,000
50,000 30,000. 20,000
230,000 150,000 80,000
270,000 150,000 120,000
Traceable fixed expenses . ee 170,000 90,000. 80,000 —
Divisional segment margin............. 100,000 $ 60,000 $ 40,000
Common fixed expenses not a a
traceable to individual divisions ...... . 85,000
Net operating income..............++- $ 15,000For example, suppose that the Montvale Burger Grill expects the following operating
results next month:
Sales . $100,000
Operating expenses 3 $90,000
Net operating income .........2..... $10,000
‘Average operating assets ............ $50,000
‘The expected return on investment (ROI) for the month is computed as follows:
Net operating income Sales
jae Netoporiting income’, _Sales_
BOL Sales ‘Average operating assets
_ $10,000, $100,000
$100,000 “ "$50,000
= 10% X 2 = 20%
‘Suppose that the manager of the Montvale Burger Grill is considering investing
$2,000 in a state-of-the-art soft-serve ice cream machine that can dispense a number
of different flavors. This new machine would boost sales by $4,000, but would require
additional operating expenses of $1,000. Thus, net operating income would increase by
$3,000, to $13,000. The new ROI would be:
Net operating income Sales
Sales ‘Average operating assets
= $13,000 ,, $104,000
$104,000 “$52,000
= 12.5% X 2 = 25% (as compared to 20% originally)
ROI=For purposes of illustration, consider the following data for an investment center—
the Ketchikan Division of Alaskan Marine Services Corporation.
Alaskan Marine Services Corporation
Ketchikan Division
Basic Data for Performance Evaluation
‘Average operating assets . ‘$100,000
Net operating income $20,000
Minimum required rate of return. 15%
‘Alaskan Marine Services Corporation has long had a policy of using ROI to evaluate its
investment center managers, but it is considering switching to residual income. The con-
troller of the company, who is in favor of the change to residual income, has provided the
following table that shows how the performance of the division would be evaluated under
each of the two methods:
‘Alaskan Marine Services Corporation
Ketchikan Division
Alternative
Performance Measures
Residual
ROI Income
$100,000 $100,000
$20,000 $20,000
20%
Average operating assets (a)
NA pera meaze()
ROI, (b) = (a)....--
Minimum required return 05% x $1004 020
Residual income .......
‘The reasoning underlying the residual income calculation is straightforward. The com-
pany is able to eam a rate of retum of at least 15% on its investments. Because the
‘company has invested $100,000 in the Ketchikan Division in the form of operating assets,
the company should be able to earn at least $15,000 (15% X $100,000) on this invest-
‘ment. Because the Ketchikan Division's net operating income is $20,000, the residual
income above and beyond the minimum required return is $5,000. If residual income
is adopted as the performance measure to replace ROI, the manager of the Ketchikan
Division would be evaluated based on the growth in residual income from year to year.Alaskan Marine Services Corporation
Ketchikan Division
Performance Evaluated Using Residual Income
Average operating assets
Net operating income .. . .
Minimum required return
Residual income
*$25,000 x 15% = $3,750.
Present
$100,000
$20,000
15,000
$ 5,000
New Project
Overall
$125,000
$24,500
18,750
$ 5,750