Most corporate managers work within a budget. Their task is to make the money they spend produce the best results possible. They constantly are presented with different ways to spend their allocated money and approach the analysis of these opportunities as investments in the success of their department or organization. The first thing they want to know is what will be the return on investment, or ROI. Using the projected ROI, the manager is able to compare and choose among different opportunities.
The formula for figuring ROI is net operating profit divided by total operating assets. Net operating income is the income that comes from the operations of the company, before interest and taxes. Operating assets are cash, accounts receivable, inventory, plant and equipment, and all other assets involved in the current operations of the organization. Operating assets don't include investments made for future use or price appreciation.
If net book value, which is net of depreciation of the cost of assets, is used as the operating assets figure, the ROI will tend to increase over time, because depreciation decreases the net operating assets' value. If the gross cost of the assets is used, the actual return on the dollar investment can be seen. When using net book value, depreciation accounts for the age of equipment; however, it also discourages replacement of that equipment because the cost of new equipment will cause ROI to drop.
Benefits of ROI
Using ROI to measure productivity establishes a conceptual framework for measuring the degree of success of an organization or investment. It assigns accountability for the performance of decisions by management regarding where to invest money in the pursuit of corporate goals. It also provides a set of results that can be compared, analyzed and shared throughout the organization.
Use of ROI
Measuring ROI using a static formula gives you an idea, over time, of the direction of your company's performance. It is a benchmark that can be compared year-over-year to determine if the company is improving its performance. Just taking net profits as an indicator of performance ignores the cost of those profits. They may rise on a year-over-year basis, but without including how much was spent to create those profits, you can't know if your operations are becoming more efficient or if you are merely paying more for each dollar of profit.
- Entrepreneur: Return on Investment (ROI)
- Accounting for Management: Return on Investment (ROI) Method for Measuring Managerial Performance:
- Oak Ridge Associated Universities: Establishing an Integrated Performance Measurement System; Artley and Stroh; September 2001
- Knowledge for Health; Estimating Return on Investment for Knowledge Management Systems; BEI Consulting; 2003
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