Return on Investment (ROI)

Return on investment (ROI) is a ratio which measures gain/income generated by an investment per dollar of capital invested. It is calculated by dividing the sum of income and capital gain of an investment by the cost of investment.

Return on investment is the most common measure of an investment's performance. It is used in finance to evaluate performance of investment portfolios, and in management accounting to identify departments/projects which are more profitable per dollar of their average operating assets. Even though the exact calculation may vary depending on the context of the ROI, one thing which always holds is that a project or investment with higher ROI is always better. ROI is compared with a minimum required rate of return (also called the hurdle rate) and only those investments/projects are accepted which earn an ROI greater than the hurdle rate.

Departments/projects which earn a high ROI are considered good candidates for new investment because they are earning the most cents per dollar of new funds allocated. Unlike residual income, which measures investment return in absolute dollars, ROI measures performance in relative terms. It does not communicate any information about the dollar value of the return but works out the rate of return thus enabling us to rank different investment opportunities.

Formula

In management accounting, the following formula works out the return on investment of a department:

ROI = Net Operating Income
Average Operating Assets

Department's net operating income (also called segment margin) equals the department's revenue minus all controllable expenses.

Average operating assets of a department represents the average amount of capital invested in the department during the period. It is calculated by dividing the sum of the opening and closing operating assets balances by 2.

In case of an investment in capital markets, ROI can be calculated by dividing the sum of the (a) difference between the current value and acquisition value of the investment, and (b) dividends/interest income, by the acquisition value of the investment. Holding period return, yield to maturity, current yield, return on equity (ROE), return on assets (ROA) etc. are all different measure of ROI used in finance.

Example

CP Inc. is a company engaged in production and distribution of computers and printers. It has two main operating departments: department C specializes in design, production and marketing of computers and Department P deals in printers.

Department C has earned net operating profit of $300 million for the FY 2011 while department P has earned operating profit of $130 million for the same period. Department C had opening operating assets of $1 billion and its closing operating assets are $1.1 billion while department P had opening operating assets of $0.5 billion while its closing operating assets are $0.7 million.

CP Inc. has minimum return requirement of 12%.

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 (ROI) of 28.6% ($300 million/$1,050 million) while department P has return on investment (ROI) of 18.6% ($130 million/$700 million).

It tells that department C has performed better than department P. Since the minimum return is 12%, ROI also tells that both the departments have met the minimum return requirement.

Disadvantage of ROI

ROI suffers from a serious drawback when used in performance evaluation. It creates an incentive for managers to not invest in a project if the project's ROI is lower than the ROI of their existing projects even if the project is earning a return higher than the minimum required rate of return.

Let us consider a company which has a minimum required return of 15%. Department ABC has a current ROI of 20% and they have received a proposal for new project with an ROI of 18%.

Looking at the situation from the company's perspective, the new proposal should be accepted because its ROI is greater than the minimum required return. However, looking at it from the point of view of Department ABC, there is an incentive not to invest because accepting this proposal would reduce the composite (weighted-average) ROI.

Residual income approach addresses this weakness to some extent.

Written by Obaidullah Jan, ACA, CFA and last revised on