43. Return on Investment & Residual Income

Question 1

What is the basic Return on Investment (ROI) formula? List some of the common items used to define each part of the formula.

Answer 1

• ROI = Income ÷ Investment
• Income: After-tax net income, pre-tax income, operating profit, gross margin, or cash flow from operations.
• Investment: Total Assets, Long-term Debt and Equity (total assets − short-term debt), and Equity (total assets − total debt).

Question 2

What is the DuPont Equation as it applies to the Return on Assets formula? Briefly describe what each part of the equation measures.

Answer 2

• Profit ÷ Assets = (Profit ÷ Sales) × (Sales ÷ Assets) OR Return on Assets = Profit Margin × Asset Turnover.
• Profit Margin: Measures the percentage of sales revenue that is captured as profit.
• Asset Turnover: Reports on the number of sales dollars generated by each dollar invested into assets. Organizations that generate (turn over) a lot of sales dollars from assets can still accumulate a significant profit even if competing on a thin profit margin percentage

Question 3

Describe what the Residual Income Method represents and how it is calculated.

Answer 3

• An organization doesn’t make an economic profit until it earns enough to pay the costs of its debt and equity financing structure. This is done by establishing a hurdle rate that the organization must clear before economic value is created.
• The hurdle rate represents the organization’s minimum required ROI and is used to calculate the Required Income, which is calculated as Assets × Hurdle rate.
• The Residual Income formula is Current Income − Required Income

Question 4

What are some of the advantages and disadvantages of using Return on Investment (ROI) measures?

Answer 4

Advantages:
•Are easily understood by managers and widely used in practice.
•Make it easy to compare performance across different business units.

Disadvantages:
•Will discourage SBU managers from investing in business projects that are good for the organization if the project’s ROI will dilute the SBU’s current ROI.

Question 5

What are some of the advantages and disadvantages of using Residual Income measures?

Answer 5

Advantages:
•Avoids the ROI incentive problem on projects with desirable rates of return that are below the high-performing SBU’s current rates of return.

Disadvantages:
•The concept of capital costs and economic income is a bit more difficult to understand and communicate than the ROI concept.
•These measures can cause a bias when comparing performance between SBUs that are dramatically different in size because larger SBUs typically have an advantage in generating more residual income dollars.

Question 6

What are the three fundamental concerns with using either Return on Investment or Residual Income as the core performance measure on SBUs?

Answer 6

• Both assume that costs, revenues, and assets can be clearly distinguished between business units in the organization. It can be difficult to clearly distinguish performance of one business unit from another.
• Accounting policies occasionally shift within organizations and across economic zones. These measures can change due to accounting policy rather than actual performance.
• These measures do not provide a full strategic view of business performance. The limited perspective creates blind spots in management.