Return on Investment

Return on investment (ROI) is an accounting measure of income divided by an accounting measure of

investment.

Return on investment = Income Investment

Return on investment is the most popular approach to measure performance. ROI is popular for two reasons: it blends all the ingredients of profitabilityrevenues, costs, and investmentinto a single percentage; and it can be compared with the rate of return on opportunities elsewhere, inside or outside the company. Like any single performance measure, however, ROI should be used cautiously and in conjunction with other measures. ROI is also called the accounting rate of return or the accrual accounting rate of return. Managers usually use the term ROI when evaluating the performance of an organizations subunit and the term accrual accounting rate of return when using an ROI measure to evaluate a project. Companies vary in the way they define income in the numerator and investment in the denominator of the ROI calculation. Some companies use operating income for the numerator; others prefer to calculate ROI on an after-tax basis and use net income. Some companies use total assets in the denominator; others prefer to focus on only those assets financed by long-term debt and stockholders equity and use total assets minus current liabilities. Consider the ROIs of each of the three Hospitality hotels below. For our calculations, we use the operating income of each hotel for the numerator and total assets of each hotel for the denominator. Using these ROI figures, the San Francisco hotel appears to make the best use of its total assets.
Hotel Operating Income Total Assets

=
= = =

ROI

San Francisco Chicago New Orleans

$240,000 $300,000 $510,000

$1,000,000 $2,000,000 $3,000,000

24% 15% 17%

Each hotel manager can increase ROI by increasing revenues or decreasing costs (each of which increases the numerator), or by decreasing investment (which decreases the denominator). A hotel manager can increase ROI even when operating income decreases by reducing total assets by a greater percentage. Suppose, for example, that operating income of the Chicago hotel decreases by 4% from $300,000 to $288,000 [$300,000 X (1 - 0.04)] and total assets decrease by 10% from $2,000,000 to $1,800,000 [$2,000,000 X (1 - 0.10)]. The ROI of the Chicago hotel would then increase from 15% *to 16% ($288,000 $1,800,000). , ROI can provide more insight into performance when it is represented as two components:

which is also written as,

ROI = Return on sales * Investment turnover

This approach is known as the DuPont method of profitability analysis. The DuPont method recognizes the two basic ingredients in profit-making: increasing income per dollar of revenues and using assets to generate more revenues. An improvement in either ingredient without changing the other increases ROI. Assume that top management at Hospitality Inns adopts a 30% target ROI for the San Francisco hotel. How can this return be attained? We illustrate the DuPont method for the San Francisco hotel and show how this method can be used to describe three alter-native ways in which the San Francisco hotel

can increase its ROI from 24% to 30%.

Other alternatives, such as increasing the selling price per room, could increase both the revenues per dollar of total assets and the operating income per dollar of revenues. ROI makes clear the benefits managers can obtain by reducing their investment in current or long-term assets. Some managers know the need to boost revenues or to control costs, but they pay less attention to reducing their investment base. Reducing the investment base involves decreasing idle cash, managing credit judiciously, determining proper inventory levels, and spending carefully on long-term assets. The biggest problem with using ROI alone to evaluate managers Is this: If the expected ROI of a new project under consideration Is lower than the division's present ROI but higher than the target rate, the manager may reject a profitable project because It would lower the division's overall ROI, even though the project would be beneficial for the company. The problem with ROI Is that it measures return as a percentage rather than as a dollar amount. While It Is good to have a higher rate of return, the company Is ultimately Interested In the amount of the return, and any project with a return higher than the required rate of return will Increase the company's net profit, even though It may reduce that division's ROI, If the division's current ROI Is higher than the expected ROI of the new project. As a result of this shortcoming, ROI Is often used together with other measurement tools. Another disadvantage of using ROI for performance measurement Is that when a manager evaluated using current ROI, the pressure to meet the current period's ROI target may cause the goal of shortterm profits to take precedence over efforts to Improve long-term profits. In the long term, this can lead to reduced performance, such as when the manager reduces R&D spending, advertising, employee training or productivity Improvements In order to make current ROI look better.