Return on Investment. Comparative data on three companies in the same service in

Question

Return on Investment. Comparative data on three companies in the same service
industry are given in the table below. Study the table and respond to the questions that follow.

Company A B C

Sales $600,000 $500,000 $ ?
Net operating income $ 84,000 $ 70,000 $ ?
Average operating assets $300,000 $ ? $1,000,000
Margin ? ? 3.5%
Turnover ? ? 2
ROI ? 7% ?
a. What advantages are there to breaking sown the ROI computation into two separate elements, margin,
and turnover?
b. Fill in the missing information in the table, and comment on the relative performance of the three
companies in as much detail as the data permit. Make specific recommendations about how to
improve the ROI.

Explanation / Answer

a. What advantages are there to breaking down the ROI computation into two separate elements, margin,
and turnover?

Breaking down the ROI into two separate elements viz. margin and turnover helps the manager to see important relationships that might remain hidden if net operating income were simply related to operating assets.

First, the importance of Assets-Turnover as a key element to overall profitability is emphasized. Prior to use of the ROI formula, managers tended to allow operating assets to swell to excessive levels.

Second, the importance of sales volume in profit computations is stressed and explicitly recognized. Third, breaking the ROI computation into margin and turnover elements stresses the possibility of trading one off for the other in attempts to improve the overall profit picture. That is, a firm may shave its margins slightly hoping for a great enough increase in turnover to increase the overall rate of return. Fourth, it permits a manager to reduce important profitability elements to ratio form, which enhances comparisons between units (divisions, etc.) of the organization.


b. Fill in the missing information in the table, and comment on the relative performance of the three
companies in as much detail as the data permit. Make specific recommendations about how to
improve the ROI.
                                                           Company
                                               A                  B                C
Sales                                   600,000         500,000       2,000,0001
Net Operating Income            84,000           70,000           70,0002
Average Operating Assets    300,000      1,000,0003     1,000,000
Margin                                   14%4                14%5           3.5%
Turnover                                2.06                0.57              2.0
ROI                                       28%8                  7%               7%9

1Sales                                 1,000,000 x 2.0 = 2,000,000
2 Net Operating Income       2,000,000 x 3.5% =   70,000
3 Average Operating Assets 1,000,000 x 7%    =   70,000
4 Margin                             84,000 / 600,000 =       14%
5 Margin                             70,000 / 500,000 =       14%
6 Turnover                          600,000/300,000 =       2.0
7 Turnover                       500,000/1,000,000 =       0.5
8 ROI                                84,000/300,000     =      28%
9 ROI                                70,000/1,000,000 =       7%

Because of differences in size between Company A and the other two companies (notice that B and C are equal in income and assets), looking at net operating income and operating assets alone it is difficult to say much about comparative performance. It is difficult to determine whether Company A’s higher ROI is a result of its lower assets or its higher income. This points out the need to specifically include sales as an element in ROI computations. By including sales, light is shed on the comparative performance and possible problems in the three companies above.

Introducing sales to measure level of operations helps to disclose specific areas for more intensive investigation. Company B does as well as Company A in terms of profit margin, for both companies earn 14.0% on sales. But Company B has a lower turnover than Company A. Whereas a dollar of investment in Company A supports $2.00 in sales each period, a dollar investment in Company B supports only $0.50 in sales each period. This suggests that the analyst should look carefully at Company B’s investment. Is the company keeping an inventory larger than necessary for its sales volume? Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price level which was much lower than that at which Company B purchased its plant?

Thus, by including sales specifically in ROI computations the manager is able to discover possible problems, as well as reasons underlying a strong or a weak performance. Looking at Company A compared to Company C, notice that C’s turnover is higher than A’s, but C’s margin on sales is much lower. Why would C have such a low margin? Is it due to inefficiency, is it due to geographical location (thereby requiring higher salaries or transportation charges), is it due to excessive materials costs, or is it due to still other factors? ROI computations raise questions such as these, which form the basis for managerial action.

To summarize, in order to bring B’s ROI into line with A’s, it seems obvious that B’s management will have to concentrate its efforts on increasing turnover, either by increasing sales or by reducing assets. It seems unlikely that B can appreciably increase its ROI by improving its margin on sales. On the other hand, C’s management should concentrate its efforts on the margin element by trying to pare down its operating expenses.

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