Chapter 10, Problem 17P

Comparison of Performance Using Return on Investment
Comparative data on three companies in the same service industry are given below:

Required:
1. What advantages are there to breaking down the ROI computation into two separate elements, margin and turnover?
2. Fill in the missing information above, and comment on the relative performance of the three companies in as much detail as the data permit. Make spec (tic recommendations about how to improve the ROI (Adapted from National Association of Accountants, Research Report No. 35, p. 34)

To determine

Return on Investment (ROI), Margin and Turnover:

Return on Investment is calculated as Margin divided by Turnover. Here Margin refers to the Sales Margin and Turnover refers to the Capital Turnover Ratio.

Return on Investment calculations are important from a business standpoint as they help in evaluation of new investment proposals, make or buy decisions, capital expenditure projects and whether to invest in a particular company or not.

Advantages of breaking down Return on Investment computation into Margin and Turnover in ROI Calculations.

Answer to Problem 17P

Solution:

Advantages of breaking down Return on Investment computation into Margin and Turnover in ROI Calculations are as follows:

• It provides Detailed Informationof profits earned from capital expenditure

• It serves as a Measure of efficiencyand analysis of performance.

Explanation of Solution

• Margin is the percentage of Profit earned by an entity in a given reporting period. Profit is calculated as Revenues less Cost of Goods Sold and Indirect Expenses.

• Margin is Profit expressed in terms of Sales as a percentage.

• For example, if a company has Sales of $500 Million during a given year, and Profit is $50 Million during that period, then the Margin would be 10%

• Turnover is the capital turnover ratio. This is calculated by dividing the Sales (Turnover) for the reporting period by the entity’s capital for the year.

• For example, if a company has Sales of $500 Million during a given year, and Capital is $2500 Million during that period, then the Capital Turnover Ratio would be 10%

• Hence if the above figures of Margin and Turnover are considered, the Return on Investment, which is calculated as Margin divided by turnover, would be 50%

• Detailed information :Breaking down Return on Investment into margin and turnover elements helps in analyzing the following:

• How an investment is performing compared to the overall market conditions,
• Whether it matches up to the yardstick of the target returns expected at the time of investment,
• Whether returns are in line with predetermined industry standards and comparable investments etc.

• Measure of Efficiency :Breaking down Return on Investment into margin and turnover elements acts as a measure of efficiency in the following ways

• It helps in analyzing the returns from expenses incurred by the entity and allows for cost benefit analysis
• It enables those in charge of financial decision making of an entity to take advantage of investment opportunities by providing a tool for analysis of parameters
• It can also act as an incentive to promote healthy performance by financial decision makers such as managers by linking their incentives to achieving return on investment goals.

Conclusion

Hence the advantages of Breaking down Return on Investment into margin and turnover elements are enumerated.

2)

Return on Investment (ROI)

Return on Investment is calculated as Margin divided by Turnover. Here Margin refers to the Sales Margin and Turnover refers to the Capital Turnover Ratio

Capital Turnover ratio is calculated by dividing the Sales by the average operating assets for the year.

Average operating assets are the average of the balances of the total assets required to run operations of a business. Operating assets consist of both current and fixed assets.

Average of balances of such assets for the current and immediately preceding period is considered for Average operating assets.

To determine

Fill up incomplete table and make recommendations about the improvement of return on investment.

Answer to Problem 17P

Solution:

• The table is completed as follows:

	Company
Particulars	A	B	C
Sales	$ 600,000	$ 500,000	$ 500,000
Net Operating Income	$ 84,000	$ 70,000	$ 17,500
Average Operating Assets	$ 300,000	$ 250,000	$ 1,000,000
Margin	14.00%	14.00%	3.50%
Turnover	0.5	2	2
ROI	28.00%	7.00%	1.75%

• Recommendations to improve Return on Investment:

• Increase Revenues

• Decrease Costs

Explanation of Solution

• Margin is the percentage of Profit earned by an entity in a given reporting period. Profit is calculated as Revenues less Cost of Goods Sold and Indirect Expenses.

• Margin is Profit expressed in terms of Sales as a percentage.

• Turnover is the capital turnover ratio. This is calculated by dividing the sales by the average operating assets for the year.

• Return on Investment is calculated as Margin divided by Turnover.

• Return on Investment calculations are important from a business standpoint as they help in evaluation of new investment proposals, make or buy decisions, capital expenditure projects and whether to invest in a particular company or not.

• Given:

	Company
Particulars	A	B	C
Sales	$ 600,000	$ 500,000	?
Net Operating Income	$ 84,000	$ 70,000	?
Average Operating Assets	$ 300,000	?	$ 1,000,000
Margin	?	?	3.50%
Turnover	?	?	2
ROI	?	7.00%	?

• Formulae used:

  $Margin=\frac{NetIncome}{Sales}\times 100$

  $Turnover=\frac{Sales}{AverageOperatingAssets}\times 100$

  $ReturnonInvestment=\frac{Margin}{Turnover}\times 100$

  $AverageOperatingAssets=Sales\times Turnover$

• Calculations:

Company A:

  $Margin=\frac{NetIncome}{Sales}\times 100$

  $Margin=\frac{84000}{600000}\times 100$

Margin = 14.00%

  $Turnover=\frac{Sales}{AverageOperatingAssets}\times 100$

Turnover = 300000 / 600000

Turnover = 0.5

  $ReturnonInvestment=\frac{Margin}{Turnover}\times 100$

  $ReturnonInvestment=\frac{14}{05}\times 100$

Return on Investment = 28%

Company B:

  $\begin{array}{l}Margin=NetIncome*100/Sales\\ Margin=70000/500000x100\\ \begin{array}{l}\hfill \\ Margin=14.00\%\hfill \end{array}\end{array}$

  $\begin{array}{l}ReturnonInvestment=Margin*100/Turnover\\ Turnover=Margin*100/ReturnonInvestment\\ Turnover=14/7x100\\ Turnover=2\end{array}$

  $\begin{array}{l}AverageOperatingAssets=Sales/Turnover\\ AverageOperatingAssets=500000x2\\ AverageOperatingAssets=\$250000\end{array}$

Company C:

  $\begin{array}{l}Turnover=Sales/AverageOperatingAssets\\ \begin{array}{l}Sales=TurnoverxAverageOperatingAssets\hfill \\ Sales=2x\$1000000\hfill \\ Sales=\$2000000\hfill \end{array}\end{array}$

  $\begin{array}{l}Margin=NetIncome/Salesx100\\ \begin{array}{l}NetIncome=MarginxSalesx100\hfill \\ NetIncome=3.5x\$200000x100\hfill \\ NetIncome=\$70000\hfill \end{array}\end{array}$

  $\begin{array}{l}ReturnonInvestment=Margin/Turnoverx100\\ \begin{array}{l}ReturnonInvestment=3.5/2x100\hfill \\ ReturnonInvestment=1.75\%\hfill \end{array}\end{array}$

• Recommendations:

Increase Revenues:

It is imperative to increase the revenues by aggressively expanding and diversifying sales geographies and try to expand market share.

Competition needs to be analyzed and methods to providing greater value to customers without harming existing profits need to be innovated in order to ensure that there is sufficient year on year growth.

Decrease Costs:

Reduction of direct and indirect costs by implementing quality and performance improvement initiatives, reduction of wasteful expenses that reduce incomes etc. must be ensured.

Reduction of average operating assets of a business without reducing the sales is also a mandate to improve return on investment.

Conclusion

Hence the table is completed and recommendations to improve Return on Investment are given.