Page 74 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

Limitations Notes

ROI suffers from certain operational limitations. These are outlined below:
1. Communication Problem: Historically, accountants have used ROI in so many different
contexts that operating managers have become confused.

2. Problem with investment base: The determination/measurement of the value of
investments are referred to as "investment base". The divisional investment base requires:
(i) a precise definition of all elements that should be included and (ii) the value that
should be assigned to them.
These are, however, operational problems in respect of these aspects since different practices
are being followed and the measure of investment/assets is not standardized. Again,
problems of measuring investments in assets with an investment centre falls into two
categories viz. problems of allocation/apportionment and problems of valuation.
3. Problems with earnings: The objective of divisionalised profit reporting is to reflect those
items of expenses over which the divisional manager has some degree of control. Another
question is, to what extent corporate expenses should be allocated to the division?
A further problem in measuring the return is difficult in applying generally accepted
accounting principles to divisional earnings.

Example: One division of a company, for example, may be engaged heavily in R&D
while another may have little R&D. The first division will suffer in comparison, because of the
requirement to write off all R&D expenses in the year these are incurred.
4. Fiscal periods and timing: In a given year, different projects are in various stages of
development. Each of these promises returns more than that in the first fiscal year and
each will generate its own rate of discounted cash flow return. These are all taken on a
year-to-year basis. The return generated vertically for a period of time is, therefore,
somewhat arbitrary and can be largely dependent on accounting practices.
5. The use of ROI may distort allocation of resources in the firm.

Example: Consider a firm which is presently earning an overall ROI of 12 %. Two of its
divisions A and B have ROI of 15 % and 10 % respectively. Division A has an investment base of
` 100 lakhs and income of ` 15 lakhs; Division B has an income of ` 10 lakhs and investment base
of ` 100 lakhs. Division A has an investment opportunity which has an expected ROI of
14 % (income of `, 4.2 lakhs in relation to investment of ` 30 lakhs); Division B has an investment
opportunity which has an expected return of 11 % (income of ` 3.3 lakhs in relation to investment
of ` 30 lakhs). Division A is likely to reject the investment opportunity of earning 14 % ROI
because it causes a decline in its divisional ROI. Yet this investment opportunity is desirable
from the overall company point of view. Division B is likely to accept the investment opportunity
of earning 11 % ROI because it enhances its division's ROI. Yet this investment opportunity is
not desirable from the overall company point of view.

4.8 Economic Value Added (EVA) (Residual Income)

An alternative measure of financial performance in an investment centre is segment.

Economic Value Added (EVA) is the amount in rupees that remains after deducting an "implied"
interest charge from operating income. The implied interest charge reflects an opportunity cost,
and is charged on the amount of assets in each investment centre. The rate of interest charge is

LOVELY PROFESSIONAL UNIVERSITY 69