In a truly decentralized company, segment managers are given a great deal of autonomy.

Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the best in the company.

Competition between investment centers is particularly keen for investment funds.  How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide which investment centers are most profitability using the funds that have already been entrusted to their care?  One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI).

Definition of Return on Investment (ROI):

The return on investment (ROI) is defined as net operating income divided by average operating assets.

ROI Formula / Equation:

[ROI = Net operating income / Average operating assets]

Net operating income and operating assets defined:

Net operating income rather than net income is used in the ROI formula. Net operating income is income before interest and taxes and is sometimes referred to as earnings before interest and tax (EBIT) Net operating income is used in the formula because the base (i.e. denominator) consists of operating assets. Thus, 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 productive use in the organization. Examples of  assets that would not be included in operating assets category would include land held for future use, an investment in another company, or a building rented to someone else. These are also called non operating assets.

The operating assets used in the formula is typically computed as the average of the operating assets between the beginning and the end of the year.

Plant and Equipment: Net Book Value or Gross Cost?

Determining the dollar amount of plant and equipment that should be included in the operating assets base is a major issue in ROI computations.

Example:

Assume that a company reports the following amounts for plant and equipment on its balance sheet: