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ROI - A significant divisional performance measure
01-06-2006, 07:47 PM
Post: #1
ROI - A significant divisional performance measure
Look at the following divisional results
Divisions
South North
Controllable contribution 25000 40000

Could we conclude that North division has performed well? We cannot say about the performance unless we know about the capital invested in each division.
Instead of using an absolute measure, corporation use return on investment to evaluate the divisional performance. Return on investment represents the divisional profits as a percentage of the assets employed in the division. Assets employed can be defined as the total divisional assets, controllable assets, or net assets. Let¡¦s have the capital investment of each division
Divisions
South North
Controllable contribution 25000 40000
Assets employed 200000 400000
Return on capital employed 12.5% 10.0%

We can now safely conclude that South division performed well as far as the return on investment is concerned; however, absolute measures could undermine the performance. This is why the absolute measure is not useful for performance measurement. The absolute measure will be a safe measure in case where each division has employed the same amount of resources, but this situation is highly impractical.
Capital invested has alternate uses; therefore, corporate management would wish to ascertain whether the division is covering the cost of capital or not. For example, if cost of capital is 11%, South division is recovering it, and the viability of North division is unquestionable if the return couldn¡¦t be improved. Therefore, return on investment is widely used to compare the performance of dissimilar divisions.

SHORTCOMING OF ROI
A number of problems exist when return on investment is used to evaluate the managerial performance. Following two are very critical

First, incorrect investing decisions
Evaluating performance on the basis of ROI may not encourage goal congruence. Append the following data to the data presented above
Both divisions have a chance to invest in certain projects; here are details
Divisions
South North
Investment opportunity 50000 50000
Proposed return 12% 10.5%
Remember, the cost of capital is 11%. In this circumstance, both managers will not make the decision in favor of overall organization, lacking goal congruence. Let¡¦s see how¡K
ƒx First, talk about south division. Since the division is currently earning 12.5% return, any investment opportunity that yields below this return would cause this return to reduce. Therefore, even through the new investment opportunity is in the interest of the company (it is covering cost of capital), the division would not undertake the investment. The reason could be that most managers are rewarded on the basis of ROI.
ƒx As far as the north division is concerned, it tends to undertake investment because no matter it is not covering the cost of capital, it would cause to improve ROI.

Second, incorrect disposal decisions
Generally speaking, asset should be disposed off if it yields the return below of cost of capital. Consider the following case.
Both divisions have identified the assets having the following information
Divisions
South North
Asset cost 20000 20000
Return 12% 10.5%

„` South division would tend to dispose off the asset because it will increase its own ROI; however, the return is still covering the cost of capital.
„` North division would hold the asset because the asset is yielding the return in excess of overall division; nevertheless, the return of the asset is insufficient to cover the cost of capital.

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Umar
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