In: Accounting
In what way can the use of ROI as a performance measure for an investment center lead to bad decisions? How does the residual income approach overcome this problem? Discuss how this could impact motivation of managers If a company switches from using ROI to residual income as a measure of performance.
Return on investment (ROI) measures return as a relative percentage of invested assets in a division. ROI often leads to bad decision of rejecting a new investment project. For example if a division is having a ROI based on past performance of 20% and if new investment ROI is 18% the new investment is rejected since the previous ROI of 20% is not met. Whereas if the organisation is having a cost of capital of 15% the project is beneficial to the organisation as a whole since the ROI is exceeding cost of capital and gives positive return to the firm. Hence Return on investment is not an adequate measure for accepting or rejecting the investment alternative. To overcome this drawback Residual income is often preferred. In residual method cost of capital is deducted from operating profit. If the residual income is positive the project is accepted and if residual income is negative the project is rejected. Residual income helps in maximising the returns to the company and accepting projects which yield returns over cost of capital.
Mangers when evaluated on ROI basis are bound to accept the projects that yield ROI in excess of their prior year ROI. Hence managers do not feel motivated to accept projects which are having lower ROI. However if the firm changes its method of evaluation to residual income the managers can accept the projects having positive residual income