The return on operating assets measurement focuses attention on only those assets used to generate revenue. Once measured, a common outcome is that management works to minimize all of the other assets on the books that are not contributing to revenue. The calculation for the return on operating assets is to divide net income by the gross recorded amount of all assets used to generate revenue. Two issues related to the calculation are:
- Depreciation. Including depreciation in the denominator is not recommended, since accelerated depreciation can skew the result.
- Unusual income. If there is unusual income not related to the ability of assets to generate revenue, exclude it from the numerator.
Also, the assets to be included in the denominator are subject to a considerable amount of interpretation. Managers will likely realize that assets not included in the measurement will eventually be questioned, so expect them to dump as many assets as possible into the calculation.
As an example of how the return on operating assets can be used, Giro Cabinetry has acquired a number of assets through various acquisitions that may no longer be needed. The president tells the controller to develop a return on operating assets measurement, with the intent of spotting equipment that can be disposed of. The controller assembles the following information:
- Net income for the past year was $500,000
- The gross amount of assets on the books is $4,000,000
- There are three excess lathes, recorded at $65,000 in total
- There are two excess band saws, recorded at $35,000 in total
- There is an extra CNC machine, recorded at $300,000
Based on this information, the company's return on operating assets is:
Net income ÷ Assets used to create revenue
$500,000 Net income ÷ ($4,000,000 Gross assets - $400,000 Unproductive assets)
= 13.8% Return on operating assets
A concern with the use of this ratio is that a company may strip out assets that were being held in reserve to deal with peak demand situations. If such assets are eliminated, a business may not be able to meet customer orders when demand spikes.