RETURN ON INVESTMENT (RO!) eturn on investment or RO! is a profitability ratio that calculates the profits of an investment as a percentage of the original cost. In other words, it measures how much money was made on the investment as a percentage of the purchase price. It shows investors how efficiently each dollar invested ina project is at producing a profit. Investors not only use this ratio to measure how well an investment performed, they also use it to compare the performance of different investments of all types and sizes, In equipment. It doesn’t matter what the n only looks that the profits and the costs ‘For example, an investment in stock can be compared to one type of investment because the return on investment calculatioy associated with the investment. That being said, the ROI calculation is one of the most common investment ratios because it’s simple and extremely versatile. 7. © Managers can use It to compare performance rates on capital equipment ourchases * Investors can calculate what stock purchases performed better. RMULA The return on investment formula is calculated by subtracting the cost from the total income and dividing it by the total cost. ROT = Net Profits «100 Cost of Srvestment™ 4 . OR [ por = Snvedinent Revenue — Srilestmer co ————— ees Qrvediment Cost h ‘As you can see, the ROI formula is very simplistic and broadly defined. What | mean by that is the income and costs are not clearly specified. Total costs and total reveriues can mean different things to different individuals. For example, 77 manager might use the net sa equation * Investor might Jook more global at the equation and use gross sales ant all expenses incurred to produce or sell he product including operating and non-operating costs. and cost of goods sold as the revenues and expenses in the |__Inthis way, the RO! calculation can be very versatile, but it can also be very m<.sigulative depending on what the user wants tu measure or shiow. It’s Important to realize that there is no one standardized ~ [equation for return on investment. instead, we'll ook at the basic idea of recognizing profits as 9 percentage of income. To truly unders:and the return on an investment presented to vou eu have t understand what revenues and costs are being used in the calculation, youryourave reEXAMPLES a stockbroker who specializes in p., “ ear when he purchas., 1t’s look at Keith’s Brokerage House for ‘example. Keith Is stocks. Keith made a somewhat risky Investment in @ liquid metals stock last y' ir market value of per share Is $3.50. Keith se. 5,000 shares at $1 per share. Today, a year later. the fal the share and uses an RO! calculator to measure his performance. (s00 sues) — Sev Y Ros $17500-$5000 _ 950!) oth a : me \2858 a that Keith made $2.50 for 1u can see, Keith's return on investment is 2.5 or 250 percent. This means 0 xtremely efficient cS Ge dollar that he invested in the liquid metals company. This investment was © because it increased 2. times. you: “ais with his other financial choice of investing in a We can compare Keith's good choice of liquid meti hares at $1 per share and sold them for $1.25 per (x Xf Ae)- [20 medical equipment company. He purchased 1,000 st share. . vo 25" —_— VY ROL. = $1250- $1000 + § 1000. - Keith’s return on this stack purchase was only .25 or 25 percent. It’s still a good return, but nothing compared to the other investment. ‘in the context of management accounting, return on investment (ROI) is a metric used to measure Fone on of departments in relative terms. It calculates departments’ return on their average ‘operating assets. Departmertg Net Operating Sncome ROL = Average Operdting Ascéls of tthe depaviment, Department's net operating income is the department's revenue minus all expenses for which the department manager is responsible. ‘Average operating assets of the department represent the asset base of the department Example: cP inc. sa company engaged In production and distribution of computers and printers. It has two main operating departments: department C specializes in desi i Hi ign, production computers and Department P deals in printers. a al Department C has earned net operating profit of $300 million for the FY 2011 while department earned operating rrofit of $130 million for the same period, Department Chad Opening cea sel a 2Yj '$1 billion and its closing operating assets are $1.1 billion while department P had opening Operating ets of $0.5 billion while its closing operating assets are $0.7 m milion ements) \28r Solution Department C's average operating assets are $1.05 billion while department P's average operating assets are $0.6 billion, Department C has a return on investment (RO!) dapeanoms {$1,050 million) while department P has return on investment (RO!) os) g30 million/$700 million). Ittells that department Chas performed better than department P. Since the minimum return Is 12%, ROL also tells that both the departments have met the minimum return requirement, GIVEN ‘DBssued and Subscribed capital ; 2000 equity Shaves of F 100 each 2oooo / 1000, B+ Preference Share of © looeach tooo.” 300000 Reserve & Surplus: Reserve Revenue 30000! Capital Reserve Soo0o/ Resewe for contijenctes Qoooo : 100000 Net Profi ana 'rofit before Britevest & stax \Soo00 LA Tok Rate @ 5eo'/, & also Sriferest charges axe (E30000. — Calculate Retim on Shareholders Snvestment e Solution — NPB9 &T 150000 ©) Briterest: /* (30000). ° Net Mega os lan }20000 ©) tax @ S07. (60000) NPA® &T “Gocon \eRe . unatenolder's Snvestment = Equity Shave capital + Pref Share Capital + Resene = £20000 + 00000 + 100000 =~ E Yooooo , / Relarn on Shareholder’s Snvlestmenit = NPASaS Shareholder's SWVesThresit = 60000 yx 400 Yoo00e © He | Sans MOP bl ANALYSIS Bees Generally, any positive RO! is considered a good return. This means that the total cost of the investment was recouped in addition to some profits left over. A negative réturn on investment means that the revenues weren't even enough to cover the total costs. That being said, higher return rates are always better than lower return rates. Going back to our example about Kelth, the first investment yielded an ROI of 250 percent, where as his second investment only yielded 25 percent. The first stock outperformed the second one tenfold. Keith would have been better off investing all of his money into the first stock. The ROI calculation is extremely versatile and can be used for any investment. Managers can use it to measure the return on invested capital. Investors can use it to measure the performance of their stock and individuals can use it to measure their return on assets like their homes. . One thing to remember is that it does not take into consideration the time value of money. For a simple purchase and sale of stock, this fact doesn’t matter all that much, but it does for calculation of a fixed asset like a building or house that appreciates over many years. This is why the original simplistic earnings Portion of the formula is usually altered with a present value calculation. | ADVANTAGES OF ROI 1, Better Measure of Profitability: It relates net income to investments made in a division giving a | better measure of divisional profitability, All divisional managers know that their performance will be |udged in terms of how they have utilized assets to earn profit tis will encourage them to make optimum use of assets, Also, it ensures that assets are acquired only when they are sure to give returns in consonance with the organisation's policy. Thus, the major focus of ROI Is on the required level of investment. For a given business unit ata 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Ri ee vnatenolder's Investment = Equity Sheva cor ai Pref Share Capitol + Reserve = £20000 + lo0000 + 100000 = E4000, + 7 Relarn on Shareholder's Srvestmenit Te fe BrnWestrentt = 60000 yx 400 =! 81) Yooo0d © | oh. bose yoo L ~ 3) ANALYSIS “Zoecee Generally, any positive RO! Is considered a good return. This means that the total cost of the investment was recouped in addition to some profits left over. A negative réturn on investment means that the revenues weren't even enough to cover the total costs. That being said, higher return rates are always better than lower return rates. Going back to our example about Kelth, the first investment yielded an RO! of 250 percent, where as his second investment only yielded 25 percent. The first stock outperformed the second one tenfold. Keith would have been better off investing all of his money into the first stock. The ROI calculation is extremely versatile and can be used for any investment. Managers can use It to. measure the return on invested capital. Investors can use it to measure the performance of their stock and individuals can use it to measure their return on assets like their homes. Che thing to remember Is that it does not take into consideration the time value of money. For a simple purchase and sale of stock, this fact doesn’t matter all that much, but it does for calculation of a fixed asset like a bullding or house that appreciates over many years. This is why the original simplistic earnings portion of the formula is usually altered with a present value calculation. ADVANTAGES OF ROI 1. Better Measure of Profitability: it relates net income to investments made ina division giving better measure of divisional profitability. All divisional Managers know that thelr performance will be {udged in terms of how they have utilized assets to earn profit, this will encourage them to make optimum use of assets. Also, it ensures that assets are acquired only when they are sure to give returns in consonance with the organisation's policy, Thus, the major focus of ROI is on the required level of Investment. 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oy di sat could i S//Mewestments that would reduce the division's ROI but could increase the value relected by the divisional manager. It is likely that another division may invest wala that might improve its existing ROI (which may be lower than a division's RO! whic! the investment) but which will not contribute as much to the enterprise as 3 whole- investment proposals. This ullows them to choose an investment that will enhance Organisational profit performance as well as enable effective utilisation of existing iment onal nd ents, Achieving Goal Congruence: RO! ensures goal congruence between the different di firm. Any increase in divisional ROI will bring improvement in overall RO! of the entire org none 2 the janization, 3. Comparative Analysis: KO! helps in making comparison between different business ur of profitability and asset utilization. It may be used for inter firm comparisons, provided ¢ whose results are being compared are of comparable size and of the same Industry. ROI a good meas: ure because It can be easily compared with the related cost of capital to decide the selection of Investmen: opportunities. men nits in term; hat the firm: 4, Performance of Investment: RO! is significant in measuring the performance of investmen division which focuses on earning maximum profit and making appropriate decisions regarding acquisitior and disposal of capital assets. Performance of investment centre manager can also be assessec advantageously with RO!. 5, ROL as Indicator of Other Performance Ingredients: RO! is considered the single mos important measure of performance of an investment division and it includes other performance aspect of a business unit. A better RO! means that an investment centre has satisfactory results in other fields o performance such as cost management, effective asset utilization, selling price strategy, marketing ant promotional strategy etc. &. Matching with Accounting Measurements: ROI is based on financial accounting measurement accepted in traditional accounting. It’ does not require a new accounting, measurement to generat information for calculating ROI. Ail the numbers required for calculating ROI are easily available in inanciz statements prepared in conventional accounting system. Some adjustments in existing accountin y numbers may be necessary to compute ROI, but this does not pose any problem in calculating RO!. DISADVANTAGES OF ROI: 1. Satisfactory definition of profit and investment are difficult to find, Profit has many concepts such: _ profit before interest and tax, profit after interest and tax, controllable profit, profit after deductin allocated fixed costs. Similarly, the term investment may have many connotations such as gross boc value, net book value, historical cost of assets, and current cost of assets, asséts Including or excludie intangible assets. . . 2. While comparing ROI of different companies, it is necessary that the companies use similar account? Policies and methods in respect of valuation of stocks, valuation of fixed assets, apportionment « overheads, treatment of research and development expenditure, etc. w fh rates of return. Otht ne of the business may 4. the available funds in has rejecte . RO! may influence a divisional manager to select only investments with hie!These types of decisions are sub-optimal and can distort an enterprise's overali allocation of reso. and can motivate a manager to make under investing in order to preserve its existing ROI. A goog das an OI in excess of some minimum desired rate of return, usually base, satisfactory return is di on the firm's cost of ca; ital Business units having higher ROI and sorne other units having lower RO! are impacted differently by using ROI as investment selection criterlz, RO! evaluation provides disincentive to the best division (having higher ROl) to grow, whereas the clvision with the lowest ROI will have an incentive to invest in new projects to improve their ROI. In this situation, the most profitable units are demotivated to invest in a project that does not exceed their current ROI, although the project would give a good return. This may be in conflict with goalcongruence and interests of the firm as a whole. Suppose a division’s ROI is 25% ROI = Profit Rs 1,00,000/Investment F's 4,00,000 x 100 Suppose, there is an opportunity to make additional investment of Rs 2,00,000 which will give 20% ROI. This investment is inacceptable to the company because the company requires a minimum 15% RO! for this type of investment. This investment lowers the division's ROI to 23.3% calculated as follows: New RO! = Rs 1, 00, 000 + (Rs 4,00,000/Rs 4,00 000) + (Rs 2, 00, 000 x 100) A comparison of old RO! (25%) with the new RO! (23.3%) would imply that performance has declined. Consequently, a divisional manager might decide not to make such an investment. 4. ROI provides focus on short term results and profitability; long term profitability focus is ignored. ROI considers current period’s revenue and cost and do not pay attention to those expenditures and investments chat will increase long term profitability of a business unit. Based on ROI, the managers tend te avoid the new investments and expenditure due to returns being uncertain or return may not be realized for some time. Managers using ROI may cut spending on employee training, Productivity improvements, advertising, research and development with the narrow objective of Improving the current ROI. However, these decisions may impact long term profitability negatively.” Therefore, it Is advisable for the investment division or business unit to use ROI as only one parameter of an overall evaluation criteria to decide the acceptances/rejection of new investment. 5. Investment Centre managers can influence (manipulate) RO!_by changing accounting policies, determinaticn of investrnent size or asset, treatment of certain items as revenue or apital. Sometimes, managers may reduce the investment base by scrapping old machines that still earn a positive return but less than others. Thus, the practice of abandoning old machines that are still serviceable may be used by managers to increase their RO| and a series of such actions may be harmful to the orgatilsation as a whole.» °%, ye 44 Sy ; w is RO! used for evaluating business case scenarios ? HO ? “ae which business case scenarios should the analyst recommend ? ROI! and other cash flow metrics (net cash flow, NPV, IRR and payback period) are often used to address such questions. Financial business case analyses typically look forward in time , projecting estimated cash flows (benefits) and cash outflows (costs) expected under each of two or more actions scenarios . note that one of the scenarios may be a “business as usual”(or “baseline” or “De nothing” scenario’).with two full value scenario cash flow statements. One for the proposal scenario and another for business as usual, the analyst can also construct an incremental cash flow tatement, in which all fiures represent, he increment, or differences, between corresponding ‘cost and benefit cash flow estimate in the other two cash flow statements. Other financial metrics are also called ROI In financial statements analysis where analysts assess the financial health and business performance of companies “return on capital employed” “return on total assets” “return on equity” and “return o net worth”, are sometimes called “return on investment” . in still other cases , the term sometimes refers to cumulative cash flow results over time. And, some people refer to other eae megane sh metrics as “ROI”, such as average rate of return and even internal rate of return,