In two of our previous articles we analysed how we can calculate costs and expected profits to gain a clearer picture for our investment decisions. Both of these factors can be classed in the static investment calculation category. In this category we now explore profitability forecasting.
Calculating profitability – the details
The main criterion here is the return on invested capital, i.e. profitability. The formula is relatively simple. We divide the expected profit with the invested capital, and multiply by one hundred to get our profitability indicator. We use this procedure if we want to compare several projects offering similar alternatives.
Let’s take an easy example to work out the sums of investment capital and development costs. In option “A”, the purchasing and ordering is handled with a new method, while in option “B”, we improve our existing system.
When calculating profitability, the comparison shows that it is best to choose option “B” because the profitability indicator is 2.1 percentage points higher. Do not forget that this only applies if the same goal is reached with the same performance using both methods.
Pros and cons of calculating profitability
One of the drawbacks of calculating profitability is that the profit disclosed is assumed to be the same in all periods, the useful lives of assets used are not examined, and we do not consider the other impacts of capital allocation either.
One certain benefit, however, is that we can clearly focus on the optimal use of assets and achieving the most efficient return, we can clearly rank investments in line with their profitability, and afterwards we can compare the expected return with the actual result.
When do we apply the method for calculating profitability?
For investments where the capital required to buy the assets bears average interest, then calculating profitability is the best method to use. The other main category comprises development and rationalisation projects, where the profit on the various capital investments is easy to predict.