One of the most successfully used control techniques is that of measuring both the absolute and the relative success of a company or a company unit by the ratio of earnings to investment of capital. The return-on-investment approach, often referred to simply as ROI, has been the core of the control system of the Du Pont Company since 1919.
A large number of companies have adopted it as their key measure of overall performance. This yardstick is the rate of return that a company or a division can earn on the capital allocated to it. This tool, therefore, regards profit not as an absolute but as a return on capital employed in the business. The goal of a business is seen, accordingly, not necessarily as optimizing profits but as optimizing returns from capital devoted to business purposes.
This standard recognizes the fundamental fact that capital is a critical factor in almost any enterprise and, through its scarcity, limits progress. It also emphasizes the fact that the job of managers is to make the best possible use of assets entrusted to them.
As the system has been used by the Du Pont Company, return on investment involves consideration of several factors. Return is computed on the basis of capital turnover (that is, total sales divided by capital, or total investment), multiplied by earnings as a percentage of sales. This formula recognizes that a division with a high capital turnover and low percentage of earnings to sales may be more profitable in terms of return on investment than another with a high percentage of profits to sales but with low capital turnover. As can be seen, the system measures effectiveness in the use of capital. Investment includes not only the permanent plant facilities but also the working capital of the unit. In the Du Pont system, investment and working capital represent amounts invested without reduction for liabilities or reserves, on the ground that such a reduction would result in a fluctuation in operating, investments as reserves or liabilities change, which would distort the rate of return and render less meaningful. Earnings are, however, calculated after normal depreciation charges, on the basis that true profits are not earned until allowance is made for the write-off of depreciable assets.
Analysis of variations in rate of return leads into every financial aspect of the business. Rate of return is the common denominator used in comparing divisions, and differences can easily be traced to their causes.
However, other companies have taken the position that the return on investment should be calculated on fixed assets less depreciation. Such companies hold that the depreciation reserve represents a write-off the initial investment and that funds made available through such charges are reinvested in other fixed assets or used as working capital. Such a treatment appears more realistic to operating people, partly because it places a heavier rate-of-return burden on new fixed assets than on worn or obsolete ones.