- ROI is calculated as (divisional profit/capital employed) x 100%
- RI is calculated as divisional profit – (capital employed x cost of capital)
- To see how ROI and RI would treat each division, it’s a fair assumption to assume they’re both generating the same profit (as they’re virtually identical).
- Both divisions have the same assets – however the older division will have suffered more depreciation, as it is three years older – reducing its capital employed.
- Looking at both calculations, the smaller capital employed will give the older division an artificially high ROI compared to the newer division.
- Likewise, the ‘imputed interest’ (capital employed x cost of capital) for the older division will be smaller. Both divisions use the overall company’s cost of capital, thus giving the older division a higher RI than the newer division.
- If in doubt with questions like this, make up some numbers. If they both generate profits of $100k, but the older division’s assets have a NBV of $500k compared to the newer division’s $2,000k (for example), this gives ROI of 20% and 5% respectively. Similarly, if you use a cost of capital of 10% (keeping the numbers simple), this gives RI of $50k and ($100k) – both clearly favouring the older division.