Performance measurement: Return on Investment (ROI) basics

Organizations often use various metrics to measure and benchmark their performance. Performance measurement is used to understand how organizational activities translate into profits or other indicators of success, make strategic and operational decisions for the future, and control (benchmark) performance.  Performance measurement can be done at multiple levels: individual manager, business unit, a set of business units, or entire organization. Performance measurement can include financial and non-financial performance measures. In this article, we will discuss a common financial measure used to evaluate performance: Return on Investment (ROI).

1. Return on investment (ROI) formula

Return on Investment (ROI) = Profit ÷ Investment

ROI = Income ÷ Assets

Organizations can measure “profit” and “investment” in different ways. There is no single prescribed way to do so. “Profit” can be proxied with “net income” if management believes that organizational units control all costs, including tax costs. Alternatively, organizations can use a “profit” measure before taxes (e.g., operational income). Likewise, “investment” can be proxied with various accounting measures. Usually, “investment” is measured in terms of “assets” under the control of a given business unit. Sometimes, “investment” may include only assets that are both under the control and available for use in a given business unit. Overall, management has options in terms of how ROI is measured.

The fundamental principle that usually guides the choice of “profit” and “investment” is the controllability principle. Only those profits and investments that are within the control (i.e., decision making authority) of a business unit manager are often included in the ROI calculations. Items that affect the profit or investment that are not within the control of a given manager can be excluded from the ROI calculation. For example, if a business unit is allocated some common overhead costs from the headquarters office, and the manager is not in control of the allocation process or the use of those resources (i.e., the amount allocated is determined by the management in the headquarters and doesn’t directly reflect the consumption of common headquarter resources by a given business unit), those costs should be either excluded from the performance evaluation or included with a caveat: top management must understand that the arbitrary allocation of common overhead costs can affect the reported performance but may not reflect the true performance of a business unit. In this instance, better performing units are often allocated more of common overhead costs because these units can “bear” or “absorb” more costs (i.e., since they are more profitable): but such an allocation would “underestimate” the performance of profitable units. Likewise, poorly performing units are often allocated less common overhead costs because these units cannot absorb much costs (i.e., they are less profitable), and as the result, the approach will “overestimate” the performance of poorly performing units. By excluding the allocated common overhead costs (from performance evaluation) that are not within the individual unit manager’s control, the top management can better see how each business unit manages its own costs (i.e., within its control).

Speaking of managing costs, revenues, and assets, ROI can be further decomposed to get more insights into why ROI differs across different business units or time periods.

ROI = Cost Efficiency x Sales Efficiency

ROI = Profit Margin Ratio x Assets Turnover Ratio

ROI = (Income ÷ Sales) x (Sales ÷ Assets)

Cost efficiency can be proxied with the profit margin ratio (e.g., after-tax income ÷ sales). The profit margin ratio measures the manager’s ability to control costs for a given level of sales (revenues). Business units with a small profit margin ratio need to implement cost controls.

Sales efficiency can be proxied with the asset turnover ratio (i.e., divisional sales ÷ divisional assets) that measures the manger’s ability to generate sales for a given level of invested assets. Business units with a low asset turnover ratio need to review their asset utilization.

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