Question

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.

One formula for calculating return on investment is:

Operating income Invested Assets

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 Chung Company are shown.

Chung Company
Divisional Income Statements
For the Year Ending December 31, 20Y8
	Division A			Division B			Division C
Sales Revenue	$960,000			$900,000			$320,000
Operating expenses	(564,500)			(675,000)			(170,000)
Operating income before service department charges	$395,500			$225,000			$150,000
Service department charges	(275,500)			(135,000)			(70,000)
Operating income	$120,000			$90,000			$80,000

Additional financial data from the three divisions of the Chung Company are shown.

	Division A		Division B		Division C
Invested assets		$1,000,000		$600,000		$400,000

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	%	%	%

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 . 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 .

The formulas for margin and turnover are:

Margin	=
Turnover	=

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		%		%		%
Turnover

The division showing the highest operating profitability is Division .

The division showing the highest operating efficiency is Division .

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	%	%	%

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.
b.	If ROI changes, managers can determine which factor caused overall ROI to change.
c.	It is easier to calculate.
d.	Turnover can be tracked separately.
e.	Both formulas give exactly the same information, so there is no reason to use the second formula.

Answer 1

Solution

Chung Company

Calculation of return on investment for each division:

Return on investment = operating income/invested assets

Division A –

ROI = $120,000/$1,000,000 = 12%

Division B -
ROI = 90,000/600,000 = 15%

Division C –

ROI = 80,000/400,000 = 20%

Margin and Turnover –

	Division A	Division B	Division C
Margin	12.50%	10%	25%
Turnover	0.96	1.5	0.8

Computations:

Margin = operating income/sales revenue

Division A = 120,000/960,000 = 12.5%

Division B = 90,000/900,000 = 10%

Division C = 80,000/320,000 = 25%

Turnover = sales revenue/invested assets

Division A = 960,000/1,000,000 = 0.96

Division B = 900,000/600,000 = 1.5

Division C = 320,000/400,000 = 0.80

The Division showing the highest operating profitability is Division C, as its margin is highest.

The division showing the highest operating efficiency is Division B, because its turnover is highest.

Calculation of ROI applying concepts of margin and turnover:

ROI = margin x turnover

Division A = 12.5% x 0.96 = 12%

Division B = 10% x 1.5 = 15%

Division C = 25% x 0.80 = 20%

	Division A	Division B	Division C
Margin	12.50%	10%	25%
Turnover	0.96	1.5	0.8
ROI	12%	15%	20%

A company would use the second formula (ROI = margin x turnover) to calculate ROI because if ROI changes, managers could determine which factor caused overall ROI to change.