The use of ROI to evaluate performance also has disadvantages. Two negative aspects associated with ROI are frequently mentioned.
- It discourages managers from investing in projects that would decrease the divisional ROI but would increase the profitability of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI would be rejected.)
- It can encourage myopic behavior, in that managers may focus on the short runat the expense of the long run. The first disadvantage can be illustrated by an example.
Consider a Cleaning Products Division that has the opportunity to invest in two projects for the coming year. The outlay required for each investment, the dollar returns, and the ROI are as follows:
The division is currently earning an ROI of 15 percent, using operating assets of $50 million to generate operating income of $7.5 million. The division has approval to request up to $15 million in new investment capital. Corporate headquarters requires that all investments earn at least 10 percent (this rate represents how much the corporation must earn to cover the cost of acquiring the capital). Any capital not used by a division is invested by headquarters so that it earns exactly 10 percent.The divisional manager has four alternatives: (a) add Project I, (b) add Project II, (c) add both Projects I and II, and (d) maintain the status quo (invest in neither project).The divisional ROI was computed for each alternative.
The divisional manager chose to invest only in Project II, since it would have a favorable effect on the division’s ROI (15.07 percent is greater than 15.00 percent). Assuming that any capital not used by the division is invested at 10 percent, the manager’s choice produced a lower profit for the company than could have been realized. If Project I had been selected, the company would have earned $1.3 million. Bynot selecting Project I, the $10 million in capital is invested at 10 percent, earning only $1 million (0.10 x $10,000,000). By maximizing the division’s ROI, then, the divisionalmanager cost the company $300,000 in profits ($1,300,000 - $1,000,000).
The second disadvantage of evaluating performance using ROI is that it can encourage myopic behavior. We saw earlier that one of the advantages of ROI is that itencourages cost reduction. However, while cost reduction can result in more efficiency, it can also result in lower efficiency in the long run. The emphasis on short-run results at the expense of the long run is myopic behavior. Managers engaging in myopic behavior usually try to cut operating expenses by attacking discretionary costs. Examples are laying off more highly paid employees, cutting the advertising budget, delaying promotions and employee training, reducing preventive maintenance, and using cheaper materials.
The second disadvantage of evaluating performance using ROI is that it can encourage myopic behavior. We saw earlier that one of the advantages of ROI is that itencourages cost reduction. However, while cost reduction can result in more efficiency, it can also result in lower efficiency in the long run. The emphasis on short-run results at the expense of the long run is myopic behavior. Managers engaging in myopic behavior usually try to cut operating expenses by attacking discretionary costs. Examples are laying off more highly paid employees, cutting the advertising budget, delaying promotions and employee training, reducing preventive maintenance, and using cheaper materials.
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