Question

The Cosmetic Division of Persona Company is facing stiff competition from local and overseas competitors. Its operating profit has been declining steadily for the past several years. The division has been forced to lower prices so as to maintain its market share. The operating results for the past three periods are given below.

Period 1           Period 2            Period 3

Sales revenue                                                              $10,000,000         $9,500,000     $9,000,000

Operating income                                                       $1,200,000         $1,045,000         $945,000

Average assets                                                           $15,000,000      $15,000,000    $15,000,000

In period 4 the division plans to install a JIT purchasing and production system. The initiative would reduce the average operating assets by 20% compared to period 3. Further, it is estimated that the sales and operating expenses for period 4 will be restored to period 1 levels. The company has a cost of capital of 8% per annum. Return on Investment (ROI) is calculated based on average assets.

1. Discuss FOUR behavioural issues that will result if the company’s senior management insists on using ROI, rather than residual income, to assess the divisional performance and reward staff.

Answer 1

Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

Despite the fact that some adaptation of ROI is a widely used tool in management control, I feel that a strong case can be made against it because the ROI system has certain inherent limitations in it. For purposes of this discussion, it is useful to separate these limitations into two types: “technical” and “implementation.” The first type are those conditions which cause incongruities between divisional objectives and company goals, and which result in motivating division managers to take uneconomic actions. The second type includes those conditions that result from the inability, under many circumstances, to evaluate accurately the profit performance of division managers.

Technical drawbacks

The single most important limitation in this category results from the fact that ROI oversimplifies a very complex decision-making process. The use of a single ratio to measure division performance reduces investment decision making to a simple but unrealistic economic model. Under this system, any change in the investment base can be traded off against a specific amount of profit which is determined by the division’s objective rate of return.

Under the ROI control system, the economic trade-off (i.e., the ratio of investment to profits) is constant throughout the division; it is the same (a) for all assets, (b) at all times (at least, until the objective is changed), and (c) for adding additional investments as for reducing the value of investments currently on the books.

Furthermore, although the trade-off between investment and profit is constant throughout the division, it will differ among divisions where their profit objectives differ. This means that inventories in one division will have a different carrying charge from identical types of inventories in another division with a different profit objective.

Since each division is expected to earn an ROI objective, a division manager will not be likely to propose a capital investment unless it is expected to earn a return at least as high as his objective. Thus a division with an objective of, say, 20% would not want to invest at less than this rate, while a division with an objective of 5% would benefit from anything over this rate. Since it is probable that the profit objectives of most divisions are different from the company’s cutoff rate for capital expenditures, this situation can cause inconsistent capital investment actions.

Another complication under the ROI system is that different types of fixed assets must earn the same return. For example, a general-purpose warehouse that can be leased fairly inexpensively must earn the same return as special-purpose equipment that may be subject to considerable potential obsolescence. This means that divisions with high profit objectives will maximize their investment returns by leasing as much of their assets as possible. Conversely, divisions with low profit objectives might improve their returns by purchasing the same type of equipment that the other divisions are leasing.

Use of book value:

If gross book value is used, it is possible for a manager to increase his investment return by scrapping perfectly useful assets that are not contributing profits equal to the division’s objective. (When an asset is scrapped, the fixed-assets account is reduced by the original cost of the asset.) If composite depreciation is used (and most large companies use composite depreciation), the division will not even show a capital loss from disposition. This occurs because, under composite depreciation, assets are considered to be fully depreciated when they are retired.

The theory is that the depreciation rates are based on the average life of a group of assets. Some will last longer than the average; others, shorter. No gain or loss is taken, therefore, when an individual asset is retired. Even if unit depreciation is used, the loss will be less than the reduction in the investment base where assets have been depreciated. This means that the impact of scrapping a fixed asset can be favorable to the division’s ROI even where such action is clearly detrimental to the company.

In addition to encouraging the disposition of perfectly good assets, the use of gross book value will have an inconsistent effect on the investment base when equipment is replaced. The gross book value will increase only by the difference between the cost of the new equipment and the original cost of the old. The investment to the company, however, is equal to the cost of the new equipment minus the salvage value of the old equipment. In most cases, the salvage value will be far below the original cost. Thus replacement investments that are far below the company’s cutoff rate could improve the division’s rate of return.

If fixed assets are included in the investment base at net book value (gross book value minus accumulated depreciation), a division manager can reduce his investment base only by the undepreciated value. (When an asset is scrapped, the fixed asset account is reduced by the original cost of the asset; the depreciation account is reduced by the amount of accumulated depreciation applicable to the asset; consequently, the reduction in net book value is the difference between these two amounts.) If the company uses composite depreciation, the investment base will not change because, as stated earlier, all retired assets are assumed to be fully depreciated under this method. If unit depreciation is used and fixed assets are scrapped, the division will incur a loss equal to the net book value of the assets minus the salvage value. This will be equal to the amount that the investment base will be reduced.

Therefore, if fixed assets are included in the investment base at net book value, the division manager will not improve his ROI merely by disposing of fixed assets. Also, if he replaces a fixed asset, his investment base will increase by an amount equal to the net investment (cost of the new asset minus the salvage value of the old). Consequently, there is a reasonable degree of goal congruence between the division and the company with respect to the retirement and replacement of fixed assets if the assets are included in the investment base at net book value.

There is, however, a serious problem with using net book value. This problem results because the investment base of a division will be automatically reduced as the asset ages. Thus the rate of return will increase simply by the passage of time. This situation is aggravated further when a company uses some form of accelerated depreciation (as most large companies do). The amount of depreciation becomes smaller as the assets become older. This can result in very high returns on old assets. Thus, new investments are discouraged because they will reduce a division’s ROI, at least in the short run.

‘Economic value’ concept:

An alternative to using book value might be some kind of “economic value,”. Theoretically, the economic value would be the present value of the future cash flows that will be generated by an asset or a group of assets.

However, from a practical viewpoint, the implementation of this concept has a number of drawbacks. One, of course, is estimating the cash flows and determining a discount rate. Another problem is that we may have circular reasoning if we are not careful. We are trying to measure a division manager’s ROI, which is the profit earned on the investment at his disposal. Yet we are doing this by valuing his investment on the basis of estimated profits from these same investments. Still another problem is that the use of economic value will eliminate the effects of shrewd acquisitions or, conversely, poor acquisition decisions, even though one of the purposes of using ROI is to measure the effect of this type of decision.

The use of economic values is academic, in any case, because no one seems to use any values other than those from the accounting records. I believe that the reason for this is not only our inability to develop meaningful economic values, but also the reluctance of most managers to be evaluated on the basis of values that seem to be artificially created by the economist or accountant. It gives the appearance of “playing games.” Accounting records, on the other hand, are considered “real,” in spite of their obvious limitations.

Capital investment analysis:

At the time that the ROI approach began to be widely adopted, most companies used straight-line depreciation in calculating profits, and the accounting method in evaluating capital investment proposals. As a result, capital investment analysis was consistent with the subsequent measurement of profitability.

When the measurement of profitability is evaluated by gross book value, if the actual results were the same as projected, the ROI would average 5% per year over the life of the investment. If the actual performance each year turned out to be worse than the projected, the division manager’s performance would have been penalized accordingly. Consequently, the ROI method was a means for making a manager responsible for the accuracy of his investment proposals.

On the other hand, using net book value as the basis for evaluation, if the actual results were the same as projected, the investment return would be as shown in Exhibit II. Moreover, the ROI earned over the period would be the same as the return on which the capital expenditure was based. The pattern of this return would be from a low to a high return and, as I explained earlier, this is not really satisfactory for management control because it might discourage investments that would not earn an immediate payback. Over the entire period, however, the average return would be consistent with the capital investment decisions and any deviations from the capital investment estimates would be reflected in the division’s performance.

Current procedures:

Most progressive companies are using some form of discounted cash flow to make investment decisions and some form of accelerated depreciation to write off assets. As a result of these changes, the ROI earned by a division differs widely from the returns projected in the investment proposals even when actual profits are the same as projected. Let us take the previous example and assume that the company uses the time-adjusted rate of return method for making capital expenditure decisions and the sum-of-the-year’s digits for depreciating fixed assets.

Correcting the deficiencies

‘Residual income’ method:

There are three advantages to the residual income method:

1. It makes it practicable to use different rates of return for different types of assets. For example, the marginal borrowing rate can be used for inventories while the long-term cost of capital can be used for investments in fixed assets. Further, different rates can be used for different types of fixed assets to take into account different degrees of risk.

2. It can be used to require the same type of asset to earn the same return, regardless of the profitability of the particular division. Thus it establishes consistency among divisions with respect to the desirability of investing in new assets.

3. It avoids the problems that occur when a division has a very high investment return. Such a division can lower its ROI if it makes almost any new investment. It can, however, increase its residual income by any investment that yields a profit higher than the required percentage.

Although the residual income method is much better than the investment-return approach, it still does not solve one of the basic problems with ROI control. Fixed assets must still be included in the investment base at some value, and the problem of which value to use still exists. If gross book value is used, residual income can be increased by scrapping or replacing assets, regardless of the economic impact to the company. If net book value is used, residual income will increase automatically through the passage of time. Furthermore, new investments, with a satisfactory average rate of profit, will often reduce the residual income of a division in the early years. Residual income, therefore, is no better than ROI as a method of controlling investments in fixed assets.