Wednesday, July 8, 2009


Return on investment (ROI)

The performance of an investment center is usually monitored using either or both of return on investment (ROI) also known as return on capital employed (ROCE) and residual income (RI)
ROI is generally regarded as the key performance measure. There are two main reasons for its widespread use.

(a) It ties in directly with the accounting process, and is identifiable from the profit and loss account and balance sheet.
(b) Even more importantly, ROI is the only measure of performance available (apart from residual income) by which the return on investment for a division or company as a single enter unit (or collection of assets) can be measured.

Return on investment (ROI) as return on capital employed (ROCE) shows how much profit has been made in relation to the amount of capital invested is calculated as profit / capital employed) x100%

Measuring ROI

ROI can be measured in different ways,

Profit after depreciation as a % of net asset employed.
This is probably by the most common method, but it does present a problem. If an investment center maintains the same annual profit, and keeps the same asset without a policy of regular fixed asset replacement, its ROI will increase year by year as the asset get older. This can give a false impression over time.

Profit after depreciation as a % of gross assets employed.
Instead of measuring ROI as return on net assets, we could measure it as return gross assets. This would
remove the problem of ROI increasing over time as fixed assets get older.

However, using book values to measure ROI has it disadvantages.

Most important of these is that measuring ROI as return on gross assets ignores the age factor, and does not distinguish between old and new assets.

  • Older fixed assets usually cost more to repair and maintain, to keep them running. An investment centre with old assets may therefore have its profitability reduced by repair costs, and its ROI might fall over time as its assets get older and repair costs get bigger.
  • Inflation and technological change alter the cost of fixed assets. If one investment centre has fixed assets bought ten years ago with a gross cost of $1 million, and another investment centre, in the same area of business operations, has fixed assets bought very recently for $1 million, the quantity and technological character of the fixed assets of the two investment centre are likely to very different.

Tangible and intangible assets

The management account is free to capitalize or expense intangible assets. When significant expenditure on an intangible asset (such as an advertising campaign) which is expected to provide future benefits is expenses, profit will be reduced and ROI/RI artificially depressed. In the further, investment should produce significant cash inflows and the ROI/RI will be artificially inflated. Such expenditure should therefore be capitalized so as to smooth out performance measures and to eradicate the risk of drawing false conclusions from them.

A comparison of the performance of manufacturing division and service divisions should be treated with caution. The majority of manufacturing division assets will be tangible and therefore are automatically capitalized whereas the treatment of a service division’s mostly intangible assets is open interpretation.

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