Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
ROI Main Page | TOC Main Page
Question 12. from the TOC questions
How is the TOC measure of ROI = (T-OE)/I = NI/I different from Dupont’s measurement, i.e., Margin X Turnover = ( NI/Sales)(Sales/Investment) = NI/I?
Return On Investment = (Margin)(Turnover) or more specifically,
= (Profit Margin on Sales)(Capital Turnover Ratio)
= (Net Income ÷ Sales)(Sales ÷ Investment)
(See Dupont's ROI graphic).
The profit margin or Return on Sales (ROS) and capital turnover ratio are relevant in any ROI calculation, but the short ROI calculation drops sales because it appears in both numerator and denominator.
The profit margin is the rate of return on sales (ROS) and measures management's ability to control the spread between prices and costs. Productivity and cost control are reflected in this measure as well as other factors such as the level of sales.
To compare Dupont's profit margin or ROS calculations with TOC we must choose an inventory valuation method, i.e., absorption costing, direct costing, or perhaps activity based costing. If the inventory of work in process or finished goods changes, i.e., increases or decreases, there will be four different net income amounts , one for each of the three methods above, as well as one for throughput costing. Therefore, the profit margin or ROS will be different for all four methods when the number of units produced is different from the number of units sold.
If the inventory increases, ROSA > ROSD > ROST because NIA > NID > NIT.
If the inventory decreases, ROSA < ROSD < ROST because NIA < NID < NIT.
ROSA and NIA represent the return on sales and net income amounts determined using absorption costing, ROSD and NID represent these amounts for direct costing and ROST and NIT represent the amounts for throughput costing.
The capital turnover ratio reflects management's ability to generate sales from a given investment base. Total assets are typically used as the investment base although there is a controversy over whether the gross book value or net book value should be used.
When comparing traditional capital turnover ratios with TOC ratios , the denominator will always be different if there is any inventory of work in process or finished goods on hand when the ratios are calculated. This is because costs that are capitalized in absorption costing and direct costing are expensed in throughput costing. Note that the inventory does not need to change to cause TOC's total assets to be different from total assets determined under absorption costing and variable costing.
ROI may be increased by
1. Increasing Capital Turnover.
a. Increase sales with the same investment
base.
b. Decrease the investment base with the
same sales level.
2. Increasing Profit Margin or Return on Sales (ROS).
a. Increase prices with no unfavorable effects on sales.
b. Decrease cost with no unfavorable
effects on quality or increase in assets.
c. Increase sales with no changes in prices or costs.
See the ROI Read Diagram for various combinations of turnover and margin required to provide three illustrative rates of return. For example, a 20% ROI can be obtained with a turnover of 2.5 and a margin of 8%, a turnover of 2 and a margin of 10%, or a turnover of 1 and a margin of 20%. A lower turnover requires a higher margin to produce the same ROI.
The Chapter 8 Pop Company example demonstrates the difference between absorption costing, direct costing and throughput costing income statements.
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Related Chatpers and summaries:
Corbett, T. 2000. Throughput accounting and activity-based costing: The driving factors behind each methodology. Journal of Cost Management (January/February): 37-45. (Summary).
Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary). (In Chapter 4 Goldratt says that the word "cost" is a dangerous and confusing multi-meaning word and that the word "product cost" is "an artificial, mathematical phantom" p. 49).
Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary). (In Chapter 7 Goldratt tells us that the business world today has changed and cost accounting has been slow to react. They have not reexamined the fundamentals, the financial statement logic, to create new solutions. Instead, they have formulated ineffective answers like “cost drivers” and “activity-based costing.” We can no longer allocate based on direct labor. So allocating expenses at the unit level, batch level, group level, and company level is meaningless. These cannot be aggregated at their respective levels nor at the top. So why do it?).
Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).
Johnson, H. T. and R. S. Kaplan. 1987. Relevance Lost: The Rise and Fall of Management Accounting. Boston: Harvard Business School Press. (See the Relevance Lost Chapter 4 summary).
Martin, J. R. Not dated. Chapter 8: Just-In-Time, Theory of Constraints, and Activity Based Management Concepts and Techniques. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter8
Martin, J. R. Not dated. Chapter 14: Investment Centers, Return on Investment, Residual Income and Transfer Pricing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter14
Martin, J. R. Not dated. Comparing Traditional Costing, ABC, JIT, and TOC. Management And Accounting Web. TradABCJITTOC
Martin, J. R. Not dated. Drum-Buffer-Rope System. Management And Accounting Web. DrumBufferRope
Martin, J. R. Not dated. Global measurements of the theory of constraints. Management And Accounting Web. TOCMeasurements
Martin, J. R. Not dated. TOC problems and introduction to linear programming. Management And Accounting Web. TOCProblemsIntroToLP
Ruhl, J. M. 1996. An introduction to the theory of constraints. Journal of Cost Management (Summer): 43-48. (Summary).
Westra, D., M. L. Srikanth and M. Kane. 1996. Measuring operational performance in a throughput world. Management Accounting (April): 41-47. (Summary).