Return on Investment (ROI) Method for Measuring Managerial Performance:

In a truly decentralized company, segment managers are given a great deal of autonomy.

Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the “best” in the company.

Competition between investment centers is particularly keen for investment funds.  How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide which investment centers are most profitability using the funds that have already been entrusted to their care?  One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI).

Definition of Return on Investment (ROI):

The return on investment (ROI) is defined as net operating income divided by average operating assets.

ROI Formula / Equation:

[ROI = Net operating income / Average operating assets]

Net operating income and operating assets defined:

Net operating income rather than net income is used in the ROI formula. Net operating income is income before interest and taxes and is sometimes referred to as “earnings before interest and tax (EBIT)” Net operating income is used in the formula because the base (i.e.., denominator) consists of operating assets. Thus, to be consistent we use net operating income in the numerator. Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization. Examples of  assets that would not be included in operating assets category would include land held for future use, an investment in another company, or a building rented to someone else. These are also called non operating assets.

The operating assets used in the formula is typically computed as the average of the operating assets between the beginning and the end of the year.

Plant and Equipment: Net Book Value or Gross Cost?

Determining the dollar amount of plant and equipment that should be included in the operating assets base is a major issue in ROI computations.

Example:

Assume that a company reports the following amounts for plant and equipment on its balance sheet:

What dollar amount of plan and equipment should company include in its operating assets in computing ROI?

One widely used approach is to include only the plant and equipment’s net book value. That is the plant’s original costless accumulated depreciation ($2,100,000 in the example above). A second approach is to ignore depreciation and include the plant’s entire gross cost in the operating assets base ($3,000,000 in the example above). Both of these approaches are used in actual practice, even though they will obviously yield very different figures for operating assets and therefore for RIO computations.

The following arguments can be raised for using net book value to measure operating assets and for using gross cost to measure operating assets in ROI computations:

Arguments for using net book value to measure operating assets in ROI computation:

1. The net book value method is consistent with how plant and equipment are reported on the balance sheet (cost less accumulated depreciation)
2. The net book value method is consistent with the computation of operating income, which includes depreciation as an operating expenses.

Arguments for using gross operating assets in ROI computations:

1. The gross cost method eliminates both the age of equipment and the method of depreciation as factors in ROI computations. Under net book value method ROI will tend to increase over time as net book value declines due to depreciation.
2. The gross cost method does not discourage replacement of old , worn-out equipment. Under net book value method, replacing fully depreciated equipment with new equipment can have a dramatic, adverse effect on return on investment (ROI).

Managers generally view consistency as the most important consideration. As a result, a majority of companies use the net book value approach in ROI computations.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

1. Decentralization in organizations
2. Traceable and common fixed costs
3. Segment reporting and profitability analysis-segmented income statements
4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
5. Segmented Financial Information on External Reports
6. Return on Investment (ROI) for Measuring Managerial Performance
7. Controlling and Improving Rate of Return on Investment
8. Return on Investment (ROI) and Balanced Scorecard
9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
10. Residual Income-Another Method to Measure Managerial Performance
11. Limitations, Criticism or Disadvantage of Residual Income Method
12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
13. Set transfer prices at cost using variable or full (absorption) cost
14. Set transfer prices at the market price
15. Divisional Autonomy and Sub optimization
16. International Aspects of Transfer Pricing

Other Related Accounting Articles:

• Limitations, Criticism or Disadvantage of Residual Income Method
• Methods of Controlling and Improving the Rate of Return on Investment (ROI)
• Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of Performance Evaluation
• Residual Income-A Method to Measure Managerial Performance
• Return on Investment (ROI) and Balanced Scorecard
• Segmented Financial Information on External Reports
• Transfer at Cost to the Selling Division
• Set Transfer Price at Market Price
• Traceable and Common Fixed Costs
• International Aspects of Transfer Pricing