Advantages and Limitations of ROI

by admin on May 23, 2008

One of principal advantages of using return on investment to control overall performance is that it, like profit and loss control, focuses managerial attention on the central objective of the business – making the best profit possible on the capital available. It measures the efficiency of the company as a whole and of major divisions or departments, its products, and its planning. It takes attention away from mere increase in sales volume or asset size or even from the level of costs, and it draws attention to the combination of factors that promotes successful operation.

Another advantage of control by return on investment is that it is effective where authority is decentralized. It not only is an absolute guide to capital efficiency but also offers the possibility of comparing efficiency in the use of capital within the company and with other enterprises. By holding departmental managers responsible for performance in terms of the dollars invested in their parts of the business, it forces them to look at their operations from the point of view of top management. Managers often insist on heavy capital investments for new equipment or drive for lower prices to increase sales without taking into account the possible effect of their requests on the company as a whole. They also often feel isolated, particularly in large businesses, with respect to their performance. If managers are furnished with a guide to efficiency that applies to a business as a whole, they develop a keener sense of responsibility for their department or division and top managers can more easily hold subordinate managers responsible.

A further advantage of return-on-investment control, if it is complete and shows all the factors bearing upon the return, is that it enables managers to locate weakness. If inventories are rising, the rate of return will be affected; or if other factors camouflage inventory variations and leave the rate looking good, tracing back influences will disclose any weakness of the inventory situation and open the way for consideration of a remedy.

With all its advantages and its widespread use by well-managed and successful companies, this method of control is not foolproof. Difficulties involve availability of information on sales, costs, and assets and proper allocation of investment and return for commonly sold or produced items. Does the present accounting system give the needed information? If not, how much will it cost to get it, through either changes in the system or special analyses? If assets are jointly used or costs are common, what method of allocation between divisions or departments should be used? Should a manager be charged with assets at their original costs, their replacement costs, or their depreciated values? Setting up a return-on-investment control system is no simple task.

Another question is, What constitutes a reasonable return? Comparisons of rates of return are hardly enough, because they do not tell the top manager what the rate of return should be. Perhaps as good a standard as any is one that meets or surpasses the level of competing firms, since, in a practical sense, the best tends to be measured not by an absolute level but by the level of the competition for capital.





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