What is ROI how is it used in evaluating the performance of investment centers?

Investment centers are decentralized divisions or sub-units for which the manager has maximum discretion in determining not only short-term operating decisions on product mix, pricing and production methods, but also level and type of investment. An investment extends the profit center concept in that the measured profit is related to the center’s investment.

It may be described as a special form of profit center since a profitability measure is being developed for the center. The concept relating profits to assets employed have an intuitive appeal for it indicates whether the profits generated give sufficiently high return for the capital invested in the division.

ADVERTISEMENTS:

Capital is always a scarce resource, and it is important that an evaluation be made of returns that a division and the overall company are earning on invested capital.

Most companies have elaborate systems for authorizing capital expenditures. Measurement of investment center performance can be viewed as the evaluation of an aggregation of past and present capital projects as opposed to the evaluation of each project individually.

Such a measurement also provides an incentive for division managers to monitor capital investments carefully while managing their operations. The managers will also be motivated to watch the levels of inventory and receivables since these accounts will almost always be included in that investment base.

Despite the intuitive appeal investment centers, many conceptual and measurement problems may arise in the construction of a particular measure.

ADVERTISEMENTS:

Some of the problems and other issues are discussed under the following aspects:

i. Choice of an appropriate measure: Return on Investment, Residual Income, Cash Recovery Rate

ii. Choice depreciation method

iii. Measurement of assets: Current Cost or Historical Cost

Return on Investment [ROI]:

The most common measure of evaluation for an investment center is the return on investment. It is a better test of profitability and is defined in general as the division’s net income before taxes divided by some measure of assets employed in the division. Consider a division with assets of Rs.2 00 000 and net income before taxes of Rs. 50 000. Its ROI is 25 percent.

The two major ingredients of ROI are net income and invested capital. The net income when related to sales revenue gives the Net Profit ratio and when sales revenue is related to invested capital, it will give the capital turnover ratio.

Then the ROI can be derived from these two ratios as follows:

Hence, the ROI is the product of these two ratios. An improvement in either without changing the other will improve the ROI. For example, the net profit ratio is 16% and capital turnover ratio is 1.25. Then the ROI is equal to 20% [16% x 1.25].

ADVERTISEMENTS:

An increase in net profit ratio by 2% will result in increase in ROI to 22.5% [18% x 1.25]. Similarly an increase in capital turnover ratio to 1.5 will increase the ROI to 24% [16% x 1.25].

There are many positive aspects of ROI computation. It is generally an objective measure based on historical accounting data. It facilitates a comparison among divisions of different sizes and in different lines of business.

It is a common measure, since it is similar to a cost of capital for which external referents exist in capital markets. while evaluating the overall corporate profitability; the use of this measure for evaluating divisional performance encourages goal congruence between the division and the firm.

ADVERTISEMENTS:

Actions taken by a division to increase its ROI may often increase the overall profitability. Most important, perhaps, the measure focuses the division manger’s attention on the assets employed in the division and motivates the manager to invest in assets only to the extent that an adequate return can be earned on them.

If a manager were evaluated only on the level of profits, without regard to assets employed, then the tendency would be to expand assets and thereby increase profits. Such actions would lower the ROI and, therefore, will not take place when ROI is used as a performance measure.

Defects of ROI Measure:

Actions that increase the divisional ROI may make the division worse off and conversely, actions that decrease divisional ROI may increase the economic wealth of the division. For example, assume the cost of capital to the division mentioned above [with ROI of 25%] is say 15%. Suppose the division finds an opportunity of a new investment of Rs. 50, 000 that will earn Rs. 10 000 per annum. The return on this investment is 20% well above the cost of capital.

But the new ROI for the division will be 24% as shown below:

That is a decrease from the previous level of 25%. Therefore, the divisional manager may refuse this investment. Conversely, if the division has an asset costing Rs.50 000 that is earning Rs. 10 000 per year [i.e., 20% returns], the division can increase its ROI by disposing of this asset even if its return is above cost of capital:

A similar problem may arise when two divisions-with different investment bases are compared. The ROI of two divisions say, A and B are 25% and 30% with capital investments of Rs. 2, 00,000 and Rs. 1, 00,000 respectively. It might appear that division B is profitable. But on closer examination we find that division A has Rs. 1 00 000 more in assets with an incremental earnings of Rs.20 000.

Its incremental ROI is 20%, well above the cost of capital of 15%. Hence, division A is more profitable, after deducting capital costs than division B. unfortunately these things may tempt the divisional manager to manipulate the investment bases in order to maximize ROI. This problem is caused by evaluating divisional performance attempting to maximize the ratio [ROI].

Residual Income [RI]:

To eliminate the problems associated with using a ratio as a performance measure, many companies use the RI approach. RI is the difference between actual income earned by the division on an investment and the desired income on the investment as specified by minimum desired rate of return.

ADVERTISEMENTS:

It is calculated as follows:

RI = Actual Income – Desired income [maximum desired rate of return x invested capital] In effect RI is the excess of earnings above the minimum desired earnings. If the firm sets its minimum rate of return at its cost of capital, it must earn an ROI that is at least equal to the cost of funds used in making the investment.

Any amount of income earned above the cost of capital is the profit to the firm. The more the income earned above the capital charge, the better off the firm will be. In short, a firm has to maximize its RI.

Computation of RI:

The invested capital for two divisions A and B are Rs.2 00 000 and Rs. 100 000 and net income for A Rs.50 000 and for B Rs.30 000.

If the firm’s cost of capital [desired return] is 15%, then the residual income will be as shown below:

ADVERTISEMENTS:

Statement of Residual Income:

The computation shows that division A is more profitable than division B, since its RI is higher. The excess residual income of Rs.5 000 is from the incremental investment of Rs. 1 00 000. As long as the incremental ROI of any division is above the cost of capital, its residual income will be more significant RI measure.

The RI measure will always increase when investments earning above the cost of capital or eliminate investment earning below the cost of capital. Therefore, there is goal congruence between the evaluation of the division and actions that maximize the economic wealth of the division and the firm.

The firm will always prefer the division to have a higher residual income. In this regard, RI offers significant advantage over the ROI measure. The RI measure is also more flexible, since a different percentage can be applied to investments of different risk. The cost of capital will reflect a risk premium for the different kinds of risky assets. Hence, in principle, an RI evaluation permits the recognition of different risk-adjusted capital costs, whereas the simple ROI evaluation does not.

Weaknesses of RI Measure:

RI is a less convenient measure than ROI because it is an absolute number, not deflated by the size of the division. It is easier for a much larger division to earn a given amount of residual income than a small division. For example, consider two divisions, one with Rs.5 lakhs in assets and the second with Rs. 10 lakhs in assets; both have a cost of capital of 15%.

ADVERTISEMENTS:

In order to earn a residual income of Rs.50 000, the first division would need to earn a net income of Rs. 1 25 000 [an ROI of 25%] whereas the second division would have to earn Rs.2 00 000 [an ROI of 20%]. For this reason, most companies using RI evaluation will not simply direct managers to maximize residual income.

Rather they will set budgeted levels of residual income, appropriate for the asset structure of each division, evaluate divisional managers by comparing actual to budgeted residual income. However, this measure also suffers from the same limitation of ROI with regard to the maximization of economic wealth of the firm.

What is ROI and how is it applied in evaluating management?

What is ROI in investment center?

What does ROI mean and how can you use it?

In what way can the use of ROI as a performance measure for investment centers lead to bad decisions?