Return on investment
An investment center includes profit and the efficient use of assets. The traditional performance reports only measure revenue and expenses. We need a way work assets into the evaluation.
Typically when we talk about the efficient use of assets whether those assets are buildings, machinery, furniture, or stocks, we look at how much income those assets are generating. With stocks, we look at the gain on the investment and any dividends the stock pays. With company assets, like buildings and equipment, the income generated is company profit. The company uses those assets to produce products and sell those products.
Investment center performance evaluation uses return on investment (ROI) to evaluate performance.
Return on Investment = Operating Income / Total Assets
This formula will give you a percentage return on investment similar to what you would see when evaluating stocks.
Return on investment can also be calculated by using two other ratios: profit margin and asset turnover.
Profit margin is the percentage of each sales dollars that end up as profit. The higher the percentage, the better the results.
Profit Margin = Operating Income / Sales
Asset turnover tells us how efficiently the company uses assets to generate sales. The company wants to maximize the assets it has to generate as much revenue as it can. These means that the company does not want to have idle equipment or assets that are not in use. This is not a percentage, but the higher the number is the better the results.
Asset Turnover = Sales / Total Assets
Profit margin multiplied by turnover will also give you return on investment.
ROI = Profit Margin X Asset Turnover
This works because sales in the denominator of the profit margin formula cancel out sales in the numerator of the asset turnover formula.
ROI = Operating Income /
Sales X Sales / Total Assets = Operating Income / Total Assets
Investment centers use return on investment to evaluate managers because return on investment measures the efficient use of assets. A higher return on investment means higher efficiency in asset use.