ROI can be defined as profit divided by invested capital, invested capital means average assets (average fixed assets plus average working capital), it is also expressed as profit margin times asset turnover (or invested capital). It is shown in percentage, generally the higher the percentage, the better the performance.
ROI can be used as an evaluation measurement for the performance of each division within the same company. Here each division can be seen as different profit centers or investment centers on which managers could make decisions. However, ROI tends to be manipulated by managers in order to gain higher performance-related bonus.
Each division’s ROI can be compared regardless of their size, because the result is relative in nature, but sometimes managers usually choose those projects with high ROI compared with its previous ROI, it would lead to sub-optimization.
Compared with ROI, residual income (RI) may be more appropriate for investment decision purposes. Residual income=Net income from income statement－Required return, here required return equals net book value multiplied by hurdle rate.
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