Return on investment or ROI is a commonly used profit ratio standard for measurement in business. Both small and large businesses use ROI for a variety of calculations. ROI is used by a majority of managerial control devices for the evaluation of performance profits within sections of lots, particularly divisions of corporations or companies that are decentralized.
Return On Investment Limitations
Even though the business world widely accepts return on investment calculations as their high standard, this isn’t a consensus of modern business thinking. Today there are equal branches of business pointing out the seriously overlooked limitations of ROI. These are limitations that come from making corrective evaluations, in other words unqualified assumptions based on raw data. This can be demonstrated easiest with a pat umbrella response given by fans in the face of ROI criticism.
The simple version sounds like this, “Although it is agreed that return on investment calculations are not perfect, ROI is the best system currently available.”
Imagine having to say that in any normal small or larger business situations. It would be the equivalent of corporate suicide, but still this isn’t the core problem with ROI management calculations.
How Return On Investment Is Calculated
Many ways are used to determine ROI, but most popular is the applied formula of return on investments. This method divides a company’s net profits by the total assets it owns. For example a company with net profits of $500,000 having $5,000,000 in total assets would yield an ROI of .10 or 10 percent. Although this seems straight forward enough, there are serious limitations on such return on investment calculations. Mainly the rate of returns being used as the control tool.
What the rate of returns should be is often a questionable figure. Since return rates are associated with fixation of standardized return rates, these are compared against actual return rates for the core calculations. Return rate comparisons are unreliable because they do not calculate the optimal return rates, or what these should be.
Another problem lies within how valuation of investments is determined. What should the cost of assets be valuated as? Should it be original costs, replacement costs, or as costs after depreciation of assets? Inflation and economic changes cause problems in accurate calculation of pricing adjustments, since these become more acute based on whatever valuation of investment is adopted. ROI is often utilized with inflexible bias that can be counter productive for small businesses in particular. This is often true, especially when return rates are determined using the risk level for the small business. Meaning the higher the risks, the higher the desired return rate must be.
ROI Should Be Used With Flexibility
Too often, the return on investment is followed so closely that it blocks the chance to evaluate other potential data. ROI calculations tend to curtail spending money on proper research and development, which could provide more detailed data and contribute to profitable strategies for the long haul. Such neglectful attention to details makes ROI calculation potentially detrimental to small business organizations who cannot risk large scale losses on investments. As with any system of control using financial data based on ROI, excessive emphasis or extreme bias is always a potential risk factor to be avoided. It also is a way of thinking that assumes working capital is the only viable financial resource, when it is not.
Organizations should always consider the impact of skilled management, well aligned industrial partnerships, and positive public relations can afford a company. The use of ROI is only a system of measurement, it is not a reliable control for purposes of all financial data or the way a company should align itself in all situations. Never become stuck in a rut of repetitive actions, simply based on ROI calculations.
There are better management control systems that have been proposed rather than using straight ROI. Some offer improvements on management control for companies and some are still being tested in the private sectors for accuracy, but this is too large in scope to tackle in this article. The point is that ROI is has serious limitations that are often taken at face value in modern business methods. Return on investment is a style of calculation that can be easily manipulated and hurt business owners, if strictly relied upon. ROI needs to be reanalyzed in the 21st century, so that progressive new calculation methods can be incorporated for the benefit of all companies.
Jessica Kane is a professional blogger who focuses on personal finance and other money matters. She currently writes for Checkworks.com, where you can get personal checks and business checks.