Explain The Concept Of Roi. What Are Its Advantages?

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Explain the concept of ROI. What are its advantages?
Return on investment (ROI) is the ratio of profit before tax to the gross investment.
ROI is calculated with the help of the following formula:
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)

The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profit figure. One should also ignore windfalls and income from investments not related to the operations of the division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid.Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currently put to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminary expenses, etc.

ROI can be improved by
a)Increasing the profit margin on sales. b)Increasing the capital turnover c)Increasing both profit margin and capital turnover.d)Reducing cost as that adds to the total earnings of the firm.e)Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.f)Diversifying, introducing productivity improvement measures, expansion, replacement of old equipment.

Advantages of ROI
a)ROI relates return to the level of investment and not sales as the rate of return is more realistic. b)ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.
c)ROI is an effective tool for inter-firm comparison.
 

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Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment center. Explain this phenomenon with as illustration.
EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to the passage of time. Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials.All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system.

Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product development, dealer organization, and so forth may be written off as expenses, and, therefore,not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.

In view of all these problems, some companies have decided to exclude fixed assets from the investment base.These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Controllable assets are, essentially, receivables and inventory. Business unit management can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly. For example, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased; whereas, if inventories are too low, production interruptions or lost customer business can result from the stock outs. To focus attention on these important controllable items, some companies, such as Quaker Oats, 17 include a capital charge for the items as an element of cost in the business unit income statement. This acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items.

Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the anticipated cash flows, in fact, materialized. This is far from being completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if a new machine produces a variety of products, the cost accounting system usually will not identify the savings attributable to each product.

The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in excess of the company's cost of funding that investment. Investment decisions, then, are controlled at the point where these decisions are made. Consequently, the capital investment analysis procedure is of primary importance in investment control. Once the investment has been made, it is largely a sunk cost and should not influence future decisions. Nevertheless, management wants to know when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mistakes but also because safeguards to prevent a recurrence may be appropriate.

Illustration:

 
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