Return on investment is very common profitability measurement ratio. There are many ways to determine Return on investment, but the most popularly applied ROI formula is to divide net profit of a company by its total assets. For example, if your net profit is $500,000 and your total assets are $5,000,000, your ROI would be .10 or 10%. But there are some limitations of ROI (return on investment), the rate of return as a control tool:
The use of rate of return is associated with the fixation of a standard rate of return against which the actual is compared. What should be this standard return is often questionable. Comparisons of rates of return on investment are hardly enough because they do not tell what the optimum rate of return should be.
- Another problem comes in the way of valuation of investment. The question is at what cost the assets should be valued: at original cost, depreciated cost, or replacement cost. In an inflationary economy, the problem of price adjustment becomes more acute, whatever basis of valuation is adopted.
- The rate of return on investment sometimes hampers diversification if it has no flexibility. This is because of the fact that the rate of return is determined by the amount of risk; higher the risk, higher the desirable rate of return.
- Many times, the return on investment is followed so rigorously that expenditure such as research and development, which can contribute to the profitability in the long run, are curtailed to show impressive results in terms of rate of return. This practice, however, is detrimental to the organization in the long run.
- As is the case with any system of control based on financial data, return on investment can lead to excessive emphasis on financial factors. This emphasizes that capital is the only scarce resource in the organization leaving aside the role and availability of competent managers, good industrial relations and good public relations.