University:
Stanford University
Course:
ECON 202 | Microeconomics I
Academic year:

2023
Views:

395

Pages:

3
Author:

T. Elton

Return on investment This measure expresses divisional profit as a percentage of the firm's investment in the division, and is the equivalent at local level of the global 'return on capital employed' measure used in the external interpretation of accounts (see chapter 13): It recognizes that a critical test of efficiency is not the absolute size of a division's net income, but rather the relation between that income and the assets employed in its generation - for example, a profit of £100,000 on an investment of £500,000 represents a more efficient use of capital than a profit of £200,000 on a £5m investment, ceteris paribus. Capital always has alternative uses, and the firm must determine whether the returns being earned on the capital invested in a particular division exceed its opportunity cost (i.e. the returns which could be obtained from an alternative use of the capital). ROI represents a logical corollary to investment appraisal: as Kaplan and Atkinson (1989) have pointed out, most companies have elaborate systems for authorizing capital expenditures, and without some form of measurement of the ex post returns on the capital, there is little incentive for accurate estimation of the further cash flows during the capital budgeting process. Furthermore, it is argued that use of the ROI measure focuses management's attention on the control of costly items of working capital in the decentralized unit, such as stocks and debtors, whose financial impact is usually felt at central, rather than divisional, level. Breakdown of ROI For analysis purposes, as with return on capital employed, the basic formula is often broken down into the product of return on sales and investment turnover: It can clearly be seen that this 'expanded' version will produce the same ROI, because 'divisional sales' cancels out as both the denominator in the first factor and the numerator in the second, but the two following numerical examples will illustrate the significance of the breakdown for analysis and decision purposes. Example 1 A retailer of electrical and electronic equipment has franchises in several high-street department stores, as well as operating its own out-of-town discount warehouses. The same ROl of 20 per cent is earned on both businesses, but in quite different ways: Departement Stores : The store franchises earn a higher profit per f of sales, but only turn over capital twice, whereas the lower prices charged by the discount warehouses ead to a higher sales volume for every E invested, boosting the capital turnover to 3.