When ROI is used to evaluate division performance, division managers naturally try to increase it. This can be accomplished by increasing sales, decreasing costs, and decreasing investment. Three advantages of the use of ROI are as follows:
- It encourages managers to pay careful attention to the relationships among sales, expenses, and investment, as should be the case for a manager of an investment center.
- . It encourages cost efficiency.
- It discourages excessive investment in operating assets. Each of these three advantages is discussed in turn
The first advantage is that ROI encourages managers to consider the interrelationship of income and investment. Suppose that a division manager is faced with the suggestion from her marketing vice president that the advertising budget be increased by $100,000. The marketing vice president is confident that this increase will boost sales by $200,000 and raise the contribution margin by $110,000. If the division were evaluated on the basis of operating income, this information might be enough. However, if the division is evaluated on the basis of ROI, the manager will want to know how much additional investment, if any, is required to support the anticipated increasein production and sales. Suppose that an additional $50,000 of operating assets will be needed. Currently, the division has sales of $2 million, operating income of $150,000,and operating assets of $1 million.
If advertising increased by $100,000 and the contribution margin by $110,000, operating income would increase by $10,000 ($110,000 - $100,000). Investment in operating assets must also increase by $50,000. The ROI without the additional advertising is 15 percent ($150,000/$1,000,000). With the additional advertising, the ROI is 15.24 percent ($160,000/$1,050,000). Since the ROI is increased by the proposal, the divisional manager should increase advertising.
The second advantage is that ROI encourages cost efficiency. The manager of an investment center always has control over costs. Therefore, increasing efficiency through judicious cost reduction is a common method of increasing ROI. For example, Tenneco, Inc., is focusing on cost reduction in its plants by reducing non-value-added activities. Materials handling costs are very high at some plants. Improving the layout of the plants to reduce the time and distance materials must travel is a way of reducing handling costs. Notice that encouraging cost efficiency means that non-value-added costs must be reduced or productivity must be improved. There are ways to decrease costs in the short run that have a harmful effect on the business. This possibility is discussed in the section on disadvantages of ROI.
Read disadvantages of roi measure
The third advantage is that ROI encourages efficient investment. Divisions that have cut costs to the extent possible must focus on investment reduction. For example, operating assets can be trimmed through the reduction of materials inventory and work-in-process inventory, perhaps by installing just-in-time purchasing and manufacturing systems. New, more productive machinery can be installed, inefficient plants can be closed, and so on. Companies are taking a hard look at their level of investment and acting to reduce it. This is a positive result of ROI-based evaluation.
If advertising increased by $100,000 and the contribution margin by $110,000, operating income would increase by $10,000 ($110,000 - $100,000). Investment in operating assets must also increase by $50,000. The ROI without the additional advertising is 15 percent ($150,000/$1,000,000). With the additional advertising, the ROI is 15.24 percent ($160,000/$1,050,000). Since the ROI is increased by the proposal, the divisional manager should increase advertising.
The second advantage is that ROI encourages cost efficiency. The manager of an investment center always has control over costs. Therefore, increasing efficiency through judicious cost reduction is a common method of increasing ROI. For example, Tenneco, Inc., is focusing on cost reduction in its plants by reducing non-value-added activities. Materials handling costs are very high at some plants. Improving the layout of the plants to reduce the time and distance materials must travel is a way of reducing handling costs. Notice that encouraging cost efficiency means that non-value-added costs must be reduced or productivity must be improved. There are ways to decrease costs in the short run that have a harmful effect on the business. This possibility is discussed in the section on disadvantages of ROI.
Read disadvantages of roi measure
The third advantage is that ROI encourages efficient investment. Divisions that have cut costs to the extent possible must focus on investment reduction. For example, operating assets can be trimmed through the reduction of materials inventory and work-in-process inventory, perhaps by installing just-in-time purchasing and manufacturing systems. New, more productive machinery can be installed, inefficient plants can be closed, and so on. Companies are taking a hard look at their level of investment and acting to reduce it. This is a positive result of ROI-based evaluation.
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