This page covers CPA practice questions covering Return on Investment (ROI) and Residual Income that’s covered on Business Environment Concepts (BEC).
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Net Operating Income and Operating Assets Defined
Note that net operating income, rather than net income, is used in the Return on investment formula. Net operating income is income before interest and taxes and is sometimes referred to as EBIT (earnings before interest and taxes). Net operating income is used in the formula because the base (i.e., denominator) consists of operating assets. To be consistent, we use net operating income in the numerator.
Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Examples of assets that are not included in operating assets (i.e., examples of nonoperating assets) include land held for future use, an investment in another company, or a building rented to someone else. These assets are not held for operating purposes and therefore are excluded from operating assets. The operating assets base used in the formula is typically computed as the average of the operating assets between the beginning and the end of the year.
Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets. This approach has drawbacks. An asset’s net book value decreases over time as the accumulated depreciation increases. This decreases the denominator in the Return on investment calculation, thus increasing Return on investment. Consequently, Return on investment mechanically increases over time. Moreover, replacing old depreciated equipment with new equipment increases the book value of depreciable assets and decreases Return on investment. Hence, using net book value in the calculation of average operating assets results in a predictable pattern of increasing Return on investment over time as accumulated depreciation grows and discourages replacing old equipment with new, updated equipment. An alternative to using net book value is the gross cost of the asset, which ignores accumulated depreciation. Gross cost stays constant over time because depreciation is ignored; therefore, Return on investment does not grow automatically over time, and replacing a fully depreciated asset with a comparably priced new asset will not adversely affect ROI.
Nevertheless, most companies use the net book value approach to computing average operating assets because it is consistent with their financial reporting practices of recording the net book value of assets on the balance sheet and including depreciation as an operating expense on the income statement. In this text, we will use the net book value approach unless a specific exercise or problem directs otherwise.
Understanding ROI Return on Investment
The equation for ROI, net operating income divided by average operating assets, does not provide much help to managers interested in taking actions to improve their ROI. It only offers two levers for improving performance—net operating income and average operating assets. Fortunately, ROI can also be expressed in terms of margin and turnover as follows:
There are several versions of the ROI formula. The two most commonly used are shown below:
ROI = Margin x Turnover
Margin = net operating income/sales
Turnover = sales/average operating assets
Note that the sales terms in the margin and turnover formulas cancel out when they are multiplied together, yielding the original formula for ROI stated in terms of net operating income and average operating assets. So either formula for ROI will give the same answer. However, the margin and turnover formulation provides some additional insights.
Margin and turnover are important concepts in understanding how a manager can affect Return on investment. All other things the same, margin is ordinarily improved by increasing selling prices, reducing operating expenses, or increasing unit sales. Increasing selling prices and reducing operating expenses both increase net operating income and therefore margin. Increasing unit sales also ordinarily increases the margin because of operating leverage. As discussed in a previous chapter, because of operating leverage, a given percentage increase in unit sales usually leads to an even larger percentage increase in net operating income. Therefore, an increase in unit sales ordinarily has the effect of increasing margin. Some managers tend to focus too much on margin and ignore turnover. However, turnover incorporates a crucial area of a manager’s responsibility—the investment in operating assets. Excessive funds tied up in operating assets (e.g., cash, accounts receivable, inventories, plant and equipment, and other assets) depress turnover and lower Return on investment. In fact, excessive operating assets can be just as much of a drag on return on investment as excessive operating expenses, which depress margin.