Question

Synthesize data to explain the concept of ROI and describe how the use of an activity-based costing system can improve the company’s ROI and the potential impact on free cash flow.

Answer 1

Return on Investment (ROI) can be defined as an ratio between the net profit and the cost of investment resulting from an investment of some resource. A higher return on investment means the gains compare favorably to its cost. ROI is used as a performance measure by evaluating the efficiency of an investment or to compare the efficiencies of several different investments. In economic terms, it is one way of relating profits to capital employed. It is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company's profitability or to compare the efficiency of different investment.

ROI calculation is flexible with different application depending upon the user. A company may use the calculation to compare the ROI on different potential investment, while an investor could use it to calculate the return on a stock. Hence its important to know the calculation of ROI from different user perspective -

ROI = Net Income/Investment,

where Net Income = Gross Profit - Expenses

Investment = Stock + Market Outstanding + Claims.

or

Return on Investment = (Total Gain from investment - Cost of Investment)/ Cost of investment

Let us understand the ROI concept from an investor stand point. For example an investor buys a $2000 stock and sells the share after 1 year at $2400. Hence the net profit/Gain from the investment is $400. Hence ROI would be

= 400/2000*100 = 20%.

The calculation can be altered to identify net gain like after deducting taxes, fees etc to get a more accurate picture.

however though the ROI being simple to calculate can be manipulative depending upon the understanding of the Gain from different users perspective, Hence when used for comparison purpose it is important to use same input across. Also one of the other drawback is that ROI calculation does not take time into consideration. If you refer above example 20% ROI in a year is acceptable but lets just assume the stock was after two years at same price. In that case although the ROI is 20% but it is spread over two year.

Impact of Activity Based Costing on ROI and Free Cash flow -

Under Activity Based costing the costs are assigned to products, projects, services or any other unit of production depending upon the activities which goes into them as well as the resources which is consumed by them.Whereas the traditional method allocate the overhead costs based on specific factor, such as labor, materials and other source of overhead. ABC method is more logical and efficient for companies making customized product or multiple products because overhead cost are not evenly spread across all products. For example a low volume product may need minimum machine hours as well as multiple indirect cost and a high volume product may require maximum machine hours with minimum or no indirect cost. Hence if the overhead of both product is based on machine hours then the overhead costs of the low volume product would not be accurate which could result in incorrect decision making and hence significant losses.

The main goal of implementing and using Activity Based costing is to identify the actual and accurate cost for each and every product, project etc there by enabling the Business to make informed decision making as regard to profitability and the future course of action. ABC costing helps in improving the profitability and overall performance of the organization, this is achieved by identifying accurate overhead cost and cost drivers specific to each product leading to more streamline business process and decision making.

When all the direct as well as indirect cost are allocated to a product, business gets an idea as regard to which product/process are performing well and which are inefficient. Hence by streamlining this process by allocating more resources to profitable activities and eliminating practices that are costly and wasteful. Hence ABC enables better management of manufacturing process and improving the quality of product and service offerings. Overall profitability increases with informed decision making as regard to product mix and pricing hence allowing companies to offer competitive pricing while maximizing the return.

ABC costing has little or no impact on the free cash flow of the organization. The purpose of ABC costing is to provide information for decision support system and planning. ABC by itself has little or no impact on financial reports like cash flows, income statement. This is because be it ABC or traditional costing ultimately assigns cost to the same existing account, product etc. and such are cost allocation methods. However ABC model may help in improving reported margins by revealing unnecessary or inflated costs or when it shows where to adjust the workflow process or the product mix.