Mastery Problem: Return on Investment, margin, and turnover Return on Investment (ROI) The manager of an investment center should be evaluated based on revenues, costs, and investments. An evaluation based on net income ignores the amount of investment the investment center required. One way to measure operating profit in relation to investment is a calculation called the return on investment. Operating income One formula for calculating return on investment is: Invested As ROI is effective because it takes into consideration the three factors under the control of an investment center manager: revenues, costs, and investments. ROI measures the income (or return) earned on each dollar of investment APPLY THE CONCEPTS: Calculating return on investment The divisional income statements for three divisions of the Silver Company are shown. Silver Company Divisional Income Statements For the Year Ending December 31, 2013 Division A Division B Division C Sales Revenue $1,652,000 $1,075,500 $710,500 Operating expenses 974,680) 806,625) (376,565) Operating income before service department charges $677,320 $268,875 $333,935 Service department charges 568,288) (174,231) (248,675) Operating income $109,032 $94,644 $85,260 Additional financial data from the three divisions of the Silver Company are shown. Division A Division B Division C Invested assets $1,180,000 $717,000 $490,000 Calculate the return on investment for each division. If required, round the ROI to the nearest hundredth of a percent (for example, 16.943% would be rounded to 16.94%). Division A Division B Division C Return on investment 13.20 v % % Feedback Check My Work Divide Operating income by Invested Assets and express it as a percentage, rounded to to two decimal places. Margin and Turnover One way to analyze the difference in return on investment for each division is to separate the return on investment formula into two calculations: margin and turnover. Margin shows the relationship between operating income and sales. It measures the profit earned for each dollar of sales, which is a measure of operating profitability _ v . Turnover shows the relationship between sales and invested assets. It measures how many dollars of sales result from each dollar of invested assets, which is a measure of operating efficiency The formulas for margin and turnover are:Margin and Turnover One way to analyze the difference in return on investment for each division is to separate the return on investment formula into two calculations: margin and turnover. Margin shows the relationship between operating income and sales. It measures the profit earned for each dollar of sales, which is a measure of operating profitability _ v . Turnover shows the relationship between sales and invested assets. It measures how many dollars of sales result from each dollar of invested assets, which is a measure of operating efficiency V. The formulas for margin and turnover are: Operating income Margin Sales Sales Turnover Invested Assets Feedback Check My Work The Margin is a measure of income per sales dollar. Turnover is a measure of sales dollars per asset dollar. APPLY THE CONCEPTS: Calculating margin and turnover Calculate the margin and the turnover for each division. If required, round margin to the nearest tenth of a percent (for example, 14.6%) and turnover to two decimal places (for example, 0.82). Division A Division B Division C Margin % 8.80 V % % Turnover 1.40 V 1.50 1.45 The division showing the highest operating profitability is Division C- V The division showing the highest operating efficiency is Division B_- Feedback Check My Work For Margin, divide Operating income by Sales Revenue and express it as a percentage, rounded to one decimal place. For Turnover, divide Sales Revenue by Invested Assets and round to two decimal places (this is NOT a percentage).APPLY THE CONCEPTS: Using margin and turnover to calculate return on investment A second way to calculate return on investment (ROI) is Return on Investment = Margin x Turnover. Using the margins and turnovers you recorded above, calculate the return on investment for each division. If required, round the return on investment to the nearest hundredth of a percent (for example, 16.94%). Division A Division B Division C Return on investment X % 13.20 v % X % Feedback Check My Work Multiply the Margin, calculated above, times the Turnover, also calculated above. Round to two decimal places. APPLY THE CONCEPTS: Determining which ROI formula to use There are two formulas for calculating ROI: 1. ROI = Operating income / Invested Assets 2. ROI = Margin x Turnover Why would a company use the second formula (ROI = Margin x Turnover) to calculate ROI? Select the YES or NO to the following statements. a. Margin can be tracked separately. Yes If ROI changes, managers can determine which factor caused overall ROI to b. Yes change. C. It is easier to calculate. No V d. Turnover can be tracked separately. Yes Both formulas give exactly the same information, so there is no reason to use No V the second formula. Feedback Check My Work While both formulas give the same final result, the Margin/Turnover formulas break ROI into two causal factors