Which of the following is an advantage of return on investment as performance measure?

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Companies often use return on investment (ROI) as a performance measure for managers of investment centers. ROI is a financial performance measure equal to operating income divided by average operating assets. Companies calculate ROI as a percentage and compare it to the expected ROI. What are the advantages and disadvantages of using ROI as a performance measure?

One of the advantages of using ROI as a performance measure is that it is relatively easy to understand. Managers must understand performance measures if the measures are to be effective in improving performance. Another advantage is that ROI takes into account everything for which a manager of an investment center is responsible--generating revenues, controlling expenses, and managing the level of assets invested. Another advantage is that ROI is related to return on equity (ROE). Therefore, increasing ROI can lead to greater shareholder value.

What are some of the disadvantages of using ROI as a performance measure? One possible disadvantage is that ROI is a short-term performance measure. American companies receive a great deal of criticism for having too much of a short-term focus. Companies can reduce the impact of this problem by using a mix of short-term and long-term performance measures. A company might want to use the Balanced Scorecard(r) developed by Kaplan and Norton.

Another problem with ROI is that income is subject to manipulation. This factor is especially problematic if the manager has a short-term focus. For instance, the manager might be planning to leave the company in the next year. The manager could manipulate income to receive a bonus, but such manipulation could result in negative consequences for the company after the manager has gone on to other pursuits.

How could a manager manipulate income? If the manager has the authority to establish accounting principles and estimates for the investment center, the manager could change accounting principles and estimates to increase income. However, in many companies, top management is responsible for accounting principles and estimates.

If the manager cannot use such artificial means to manipulate income, the manager could use real techniques for manipulating income. One very unethical technique is channel stuffing. This technique involves sending customers in the distribution channel more products than they ordered. The hope is the customers will keep the products and pay for them. This technique will anger many customers. It could result in returns the next year and loss of customer goodwill and future business. However, the company records the sales in the year the company ships the products. The ROI will increase, which may result in a bonus for the manager. The manager may have left the company before the problems become apparent.

The manager can also time special sales and other incentives for customers to buy to increase the ROI even though the customers might have made the customers early in the next year without the costly sales incentives. Managers can also time when the investment center incurs discretionary expenses such as advertising and employee training.

Another disadvantage of using ROI as a performance measure is that it can motivate a manager not to make investments that would benefit the company. For example, assume that top management wants a manager to earn an ROI of 16 percent, which is approximately the cost of capital. The manager is currently earning and ROI of 20 percent. If an investment opportunity is available that would likely result in an ROI of 18 percent on just that new investment, the manager would be motivated to reject it. Any new investment with an ROI of less than 20 percent will result in a decrease in the manager's ROI. Yet, the company would benefit from any new investment with an ROI greater than 16 percent.

The use of ROI could motivate a manager to make an investment in a new project even though its expected ROI is less than the required rate of return. This situation could occur if the manager's current ROI is less than the required rate of return. For example, assume a manager is earning a rate of return of 12 percent, and the required rate of return is 16 percent. If a new project is expected to result in an ROI of 15 percent, the manager would be motivated to make the investment because it would cause the manager's ROI to increase. Yet, such an investment would be bad for the company because it is expected to yield an ROI less than the required rate of return.

The company could solve these investment decision problems by using residual income rather than ROI as a performance measure. Residual income is equal to operating income minus the product of the required percentage rate of return and the average operating assets.

Residual income motivates the manager to invest in all new projects that have a rate of return greater than the required rate of return and not to invest in any new projects with an expected rate of return less than the required rate of return. However, the use of residual income has an inherent bias in favor of larger divisions. Therefore, if top management uses residual income to evaluate the performance of its managers of investment centers. top management must consider this bias when comparing the performance of managers of different sizes of investment centers.

Another disadvantage of using ROI as a performance measure is that the manager may not have total control over revenues, expenses, and assets invested. The manager may be bound by contracts entered into by the previous manager. The manager may also have difficulty in disposing of assets purchased by a previous manager. Likewise, the manager begins with employees hired by a previous manager.

One of the main doctrines of management accounting is responsibility accounting. It says that a manager should be held responsible for what the manager can control and not held responsible for what the manager cannot control. Top management needs to remember this doctrine when using ROI and/or residual income to assess the performance of managers of investment centers.

Which of the following is an advantage of the return on investment ROI measure?

What are the advantages and disadvantages of ROI as a performance measure?

Why is ROI a good measure of performance?

Which of the following is not an advantage of using return on investments ROI as a performance measure?