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PPT 10-10
Appliance Division $117,000,000 3,510,000 19,500,000 $117,000,000 2,925,000 19,500,000
$40,000,000 2,000,000 10,000,000
Margin and Turnover Comparisons
Snack Food Year 1 Margin Turnover ROI 6.0% x 3.0 18.0% === Year 2 5.0% x 4.0 20.0% ===
Appliance Year 1 3.0% x 6.0 18.0% === Year 2 2.5% x 6.0 15.0% ===
PPT 10-7
Components of ROI
Decomposition of the ROI formula: ROI = Operating income/Average operating assets = (Operating income/Sales) x (Sales/Average operating assets) = Operating income margin x Operating asset turnover
PPT 10-8
10-9
Understanding ROI
Net operating income ROI = Average operating assets Net operating income Margin = Sales Sales Turnover = Average operating assets ROI = Margin × Turnover
ROI = Margin × Turnover
ROI =
Net operating income Sales
×
Sales PPT 10-13 Average operating assets
10-14
Increasing ROI – An Example
ROI = Margin × Turnover
(
Average operating assets
×
Minimum required rate of return
)
ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.
PPT 10-6
10-7
Net Book Value versus Gross Cost
Most companies use the net book value of depreciable assets to calculate average operating assets.
Acquisition cost Less: Accumulated depreciation Net book value
Suppose that Regal's manager invests in a $30,000 piece of equipment that increases sales by $35,000, while increasing operating expenses by $15,000.
Regal Company reports the following:
PPT 10-23
Residual Income Example
Project I Investment Operating income Targeted ROI $10,000,000 1,300,000 10% Project II $4,000,000 640,000 10%
assets.
PPT 10-17
Disadvantages of the ROI Measure
G It discourages managers from investing in
projects that would decrease the divisional ROI but would increase the profitability of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI would be rejected.)
PPT 10-9
An ROI Example
Year 1: Snack Foods Division Sales $30,000,000 Operating income 1,800,000 Average operating assets 10,000,000 Year 2: Sales Operating income Average operating assets Minimum return of 10%
G It can encourage myopic behavior, in that
managers may focus on the short run at the expense of the long run.
PPT 10-18
10-19
Criticisms of ROI
In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities.
PPT 10-11
10-12
Increasing ROI
There are three ways to increase ROI . . .
Reduce Increase Expenses Sales Reduce Assets
PPT 10-12
10-13
Increasing ROI – An Example
Return on Investment (ROI) Formula
Income before interest and taxes (EBIT)
Net operating income ROI = Average operating assets
Cash, accounts receivable, inventory, plant and equipment, and other productive assets.
$535,000 × $230,000
ROI = 9.35% × 2.33 = 21.8% ROI increased from 15% to 21.8%.
PPT 10-16
Advantages of ROI
G It encourages managers to pay careful attention
G Residual income = Operating income -
(Minimum rate of return x Operating assets)
PPT 10-22
10-23
Calculating Residual Income
Residual = income Net operating income
Net operating income above some minimum required return on operating assets
PPT 10-21
Residual Income
Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:
PPT 10-4
10-5
Return On Investment (ROI)
Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.
PPT 10-5
10-6
to the relationships among sales, expenses, and investment, as should be the case for a manager of an investment center.
G It encourages cost efficiency. G It discourages excessive investment in operating
ADVANCED MANAGEMENT ACCOUNTING
PPT 10-1
Performance Evaluation
PPT 10-2
Learning Objectives
G Compute and explain return on investment
(ROI), residual income (RI), and economic value added (EVA)
Net operating income Average operating assets Sales Operating expenses $ 50,000 $ 230,000 $ 535,000 $ 485,000
