Return on Investment (ROI)

In the context of management accounting, return on investment (ROI) is a metric used to measure performance of departments in relative terms. It calculates departments' return on their average operating assets.

Formula

Return on investment is calculated using the following formula:

ROI = Department's Net Operating Income
Average Operating Assets of the Department

Department's net operating income is the department's revenue minus all expenses for which the department manager is responsible.

Average operating assets of the department represent the asset base of the department.

The main advantage of the return on investment (ROI) as a performance measurement metric is that it helps in comparing performance of different departments with each other. Residual income is another performance measurement tool which calculates excess return in absolute dollar terms.

Example

CP Inc. is a company engaged in production and distribution of computers and printers. It has two main operating departments: department C specializes in design, production and marketing of computers and Department P deals in printers.

Department C has earned net operating profit of $300 million for the FY 2011 while department P has earned operating profit of $130 million for the same period. Department C had opening operating assets of $1 billion and its closing operating assets are $1.1 billion while department P had opening operating assets of $0.5 billion while its closing operating assets are $0.7 million.

CP Inc. has minimum return requirement of 12%.

Solution

Department C's average operating assets are $1.05 billion while department P's average operating assets are $0.6 billion.

Department C has a return on investment (ROI) of 28.6% ($300 million/$1,050 million) while department P has return on investment (ROI) of 18.6% ($130 million/$700 million).

It tells that department C has performed better than department P. Since the minimum return is 12%, ROI also tells that both the departments have met the minimum return requirement.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork