Methods of Controlling and Improving the Rate of Return on Investment
Return on investment is normally
used to judge the managerial performance in an investment center.
Managers therefore try to control
and improve the ROI of their investment center. Here we shall
discuss the methods of improving rate of return on investment.
The following formula is usually used for computing return on
investment (ROI) = Net
operating income / Average operating income
This formula is also discussed at
return for measuring managerial performance page. We can modify this formula slightly by introducing sales as follows:
ROI = (Net operating income /
Sales) × (Sales / Average operating assets)
These two equations are equivalent because the sales terms cancel out
in the second equation. The first term on the right hand side of the
equation is margin, which is defined as follows:
Margin = Net operating income /
Margin is a measure of management's ability to control operating
expenses in relation to sales. The lower the operating expenses per
dollar of sales, the higher the margin earned.
The second term on the right hand side of the equation is turnover,
which is defined as follows:
Turnover = Sales / Average
Turnover is a measure of the sales that are generated for each dollar
invested in operating assets.
The following alternative form of the ROI formula, which we will use
here, combines margin and turnover.
ROI = Margin ×
Both the formulas give same answer. However
margin and turnover formulation provides some additional insights. Some
managers tend to focus too much on margin and ignore turnover. To some
degree the margin can be a valuable indicator of a manager's
responsibility. Standing alone, however, it overlooks one very crucial
area of manager's responsibility--the investment in operating assets.
Excessive funds tied up in operating assets, which depresses turnover,
can be just as much of a drag on profitability as excessive operating
expenses, which depresses margin. One of the advantages of return on
investment (ROI) as a performance measure is that it forces the manager
to control the investment in operating assets as well as to control
expenses and the margin.
When return on investment (ROI) becomes a very
crucial to judge the performance of investment centers managers, managers
need to improve ROI of their centers. An investment center manager can
improve ROI in basically three ways.
To illustrate how an investment center manager can improve ROI by
making the use of three methods mentioned above consider the following
The following data represents the results of an investment center of the
operations of a company for the most recent month.
Average operating assets
The rate of return generated by the company for this investment center
is as follows:
(Net operating income / Sales) × (Sales / Average
($10,000 / $100,000) × ($100,000 / $50,000)
10% × 2
As we stated above that manager can increase sales, reduce expenses,
or reduce the operating assets to improve the ROI figure.
Approach 1: Increase sales:
Assume that the manager is able to increase sales from $100,000 to
$110,000. Assume further that either because of good cost control or
because some costs in the company are fixed, the net operating income
increases even more rapidly, going from $10,000 to $12,000 per period.
Assume that operating assets remain constant. The new ROI will be:
ROI = ($12,000 / $110,000) × ($110,000 / $50,000)
10.91% × 2.2
Approach 1: Reduce expenses:
Assume that manager is able to reduce expenses by $1,000 so that net
operating income increases from $10,000 to $11,000. Assume that both
sales and operating assets remain constant. The new ROI would be:
ROI = ($11,000 / $100,000) × ($100,000 / $50,000)
11% × 2.2
Approach 3: Reduce operating assets:
Assume that the manager of the company is able to reduce operating
assets from $50,000 to $40,000, but that sales and operating income
remain unchanged. Then the new ROI would be:
ROI = ($10,000 / $100,000) × ($100,000 / $40,000)
11% × 2.2