Anything that causes one of the variables in the numerator to increase (relative to the denominator) or one of the variables in the denominator to decrease (relative to the size of the numerator), will increase ROI. It is the relative state of an item that is important. That is, if sales increase at a greater rate than the increase in operating assets, turnover will improve and ROI will increase. If sales increase at a slower rate than the increase in operating income (because expenses are increasing at a slower rate than the increase in sales) , then margin will improve and ROI will improve.
Cutting expenses is the easiest way to improve ROI. Increasing sales (relative to operating income and operating assets) is the next best way to increase ROI. Reducing operating assets by reducing inventories (using JIT) or reducing the level of Accounts Receivable by using such thing as “lock boxes” (providing local post office boxes for customers to make payments) to reduce deposit in transit times, is the next best approach.
Criticisms of ROI
1. Managers may not know how to increase ROI in a manner that is consistent with the firm’s objectives. A balanced scorecard can be helpful in this regard.
2. A manager may take over a segment in which there are many “committed” costs (e.g. rent) over which the manager has no control. These costs may be valid in determining the performance of the segment as an investment centre but will should not be used to evaluate the performance of that manager relative to other managers.
3. When Net operating assets are used, the manager who is evaluated on the basis of ROI may reject new investment opportunities involving plant and equipment because they will adversely affect his/her ROI.
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