Financial Performance Measures for Investment Centers

Notes from the packet

Return on Investment (ROI)

measures the percentage return based on an investment in assets

• Components include:

• net operating income: earnings before interest and taxes

• average operating assets: cash, accounts receivable, inventory, PPE, and other operating assets

Return on Investment Formula

ROI = Net Operating Income / Average Operating Assets

Profit Margin

measures how much profit is earned per dollar of sales

improved by increasing the selling price, decreasing operating expenses, and increasing unit sales (lower cost per unit)

Profit Margin Formula 

Profit Margin = Net Operating Income / Sales Revenue 

Investment Turnover

measures how efficiently operating assets are being used to generate sales

improved by reducing unnecessary assets or increasing sales with the same asset base

Investment Turnover Formula

Investment Turnover = Sales Revenue / Average Operating Assets

DuPont Method

ROI = Profit Margin x Investment Turnover

Residual Income

The amount of net operating income earned over and above the minimum amount needed to meet the required rate of return

Note: the required rate of return is also referred to as the discount rate or the hurdle rate

Residual Income Formula

Residual Income = Net Operating Income - (Average Operating Assets x Required Rate of Return)

Which of the following will increase return on investment (ROI)?

• decrease sales

• decrease NOI

• increase costs

• decrease operating assets

decrease operating assets

True or false: One disadvantage of decentralization is that managers might make decisions that are good for themselves (or their division) but which are not in the best interest of the organization

True

Advantages of ROI

• easy to calculate and understand

• widely used and accepted

• independent of size (scale)

• can compare different sizes without a problem

Disadvantages of ROI

• potential goal incongruence

• decisions depend on the current ROI

Advantages of residual income

• avoids underinvestment problems with ROI

• Conceptually leads to better project selection for the company

• If it makes more money than it costs, make the product 

Disadvantages of residual income

• sensitive to size (favors large divisions)

• cannot compare differences in size