Performance measurement: Return on Investment (ROI) basics

2. ROI: where and why or why not?

First, it is important to point out that ROI cannot be used effectively as a performance measure for all organizational units. Some units or divisions do not control both profits and investments, and thus, ROI cannot be effectively used to evaluate their performance. ROI is only suitable to be used in evaluating investment centers which control both profits and investments. ROI should not be used to evaluate cost, revenue, and profit centers.

Cost centers are divisional units that manage or control only their costs. Examples: manufacturing facilities, legal departments, accounting departments.

Revenue centers are divisional units that manage or control only their sales (revenues). Examples: sales and marketing divisions that usually control sales and some marketing costs.

Profit centers are divisional units that manage or control both revenues and costs, and hence profit. For many organizations profit centers represent “regional” (lower level) divisions. For example, a manager overseeing a few units operating in a few states (e.g., Michigan – Indiana – Ohio – Illinois) for a U.S. firm that operates only in the U.S. would be likely treated as a profit center manager. A manager overseeing U.S. operations of a multinational firm with worldwide operations, would be also likely treated as a profit center manager. Within organizational hierarchies, profit center managers are often “middle-level” or “upper-level” managers.

Note, profit center managers do not control investments in their units.

Investment centers are divisional units that manage or control both profits (i.e., revenues, costs) and investments. In many organizations, investment centers represent the entire organization and some very large business units. Managers controlling the firm (e.g., executives) or some large business divisions (e.g., a vice-president of operations in North America) usually have the decision-making authority that impacts revenues, costs, and investments. Thus, executives and senior managers are often investment center managers.

While ROI is a popular performance measure used to evaluate investment centers, it has some disadvantages.

ROI Disadvantages or Limitations

  • Short-term focus: organizations usually use accounting numbers to calculate ROI. These numbers are usually monthly, quarterly, or annual and represent historic data. As such, ROI might not represent current activities. Also, it is backward-looking rather than forward-looking and cannot be used to make any strategic inferences.
  • Not optimal decision making by divisional managers: managers of profitable units might not undertake profitable for the company projects because these projects might lower their business unit’s ROI. For example, if a company has a cost of capital of 8%, it will accept all projects with the internal rate of return above 8%. If this company has a unit that generates ROI of 12%, this business unit will only accept projects that generate 12% or higher return and reject all projects under 12% return, even those projects that meet the minimum return of 8%. Thus, in this example, projects with 8 – 11.99% return that should be accepted because they generate the minimal return for the company will be rejected by the business unit with the ROI of 12%. The failure to pursue profitable projects is not optimal for the company. Also, managers might make some not optimal in the long-run operational decisions in order to “manage” the reported ROI (e.g., delay the purchase of needed machinery).
  • Subjective: while most people may think that ROI is an objective measure of performance, this is not the case. As indicated earlier, managers can measure “profit” and “investment” in different ways. Also, the choice of accounting measurement of profit and investment will impact the ROI measure overtime. For example, if managers use the net book value for their long-term assets (e.g., historical cost less accumulated depreciation), the ROI will increase overtime without a manager changing anything he or she does in the business unit because the net book value of long-term assets, holding everything else the same, declines over time as the company recognizes and allocates more depreciation expense (i.e., increases accumulated depreciation).

ROI Advantages

  • Available data: accounting systems provide data that can be used to measure ROI.
  • Business units’ size and performance comparison: because ROI scales profit by investment, it affectively measures profit relative to the unit’s size. Thus, ROI can be used to evaluate units of a different size.
  • Incentives for cost and sales efficiency: theoretically, the ROI measure should create incentives for managers to better manage divisional costs, sales, and asset utilization. However, in practice, managers might have incentives to “manage” the reported numbers rather than take actual efforts to improve divisional performance and will have an opportunity to do so because accounting choices allow managers to “manage” the ROI calculation. As such, it is important to use multiple measures of performance in addition to ROI.
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