Return on Investment - Essay Example

Critically examine the relative strengths and weaknesses of Return on Investment (ROI) as a measure of divisional performance. Table of Contents Introduction 2 Introduction Traditional measures of performance like Return on Investment (ROI), Earning per share (EPS) and Return on equity (ROE) have been widely used by the corporations to evaluate financial performance. ROI, considered as an appropriate measure of financial performance is estimated by dividing the profit with the amount of investment. As this is expressed in the form of a ratio it can be used for inter-firm and interdivision comparisons. However the use of ROI as a performance measure has attracted a lot of criticism. The traditional measures are based on historical performance and give little credence to the future performance of the company. Many companies have a strong financial performance but their activities do not generate any significant value. There are some divisions in the growth stage that may not deliver a high ROI initially. But they may have strong future cash flow projections. ROI fails to take this into account. One of the major limitations of ROI is that the managers tend to reject the projects that bring down the historical ROI even if the prospective ROI is greater than the desired ROI. These limitations are overcome by the modern measures like Economic Value Added (EVA), Residual Income (RI). This is based on the basic premise “to create value”. EVA has been heralded as the new determinant of stock prices. RI is computed by subtracting the cost of capital from the contribution of the divisions. The use of ROI as a measure of financial performance is a debatable topic. While some consider it to be flawed others regard it as an answer to their performance measurement concern. A detailed analysis relating to ROI concept and inherent strengths and weaknesses has been done in the various subsections listed below. The views of various writers have also been highlighted with respect to the concept of return on investment. ROI: Overview- ROI is calculated as the profit of a division expressed in the form of a percentage of the assets used in the division. Nowadays the company not just focuses on the absolute profits of the division rather it takes a note of the return generated by the division on the amount of investment. Assets deployed in the division can be termed as net assets, assets under the control of divisional manager or total assets of the division. ROI presents a summary of the business profitability by expressing the returns on the amount of capital investment. The use of invested capital as the base for estimating ROI means that the manager has to pay attention to the employment of working capital, particularly to debtors and stocks. ROI is used for comparing the performance of unidentical or dissimilar businesses like the various business divisions or external competitors. It is a widely practised financial measure. Literature Review ROI is simple to interpret and is commonly used by the corporate as well as individuals in making business decisions (Maguire, et al., 2008, pp. 189). As per Philips (1997b) the ROI process must balance simplicity, soundness, credibility and feasibility. According to him the common deterrents to the successful implementation of ROI include indiscipline, crude planning, time and costs, dearth of skills and false assumptions. It has been seen that the managers do not use the correct base resulting in faulty assessments. Even though the process is simple it requires financial acumen in the absence of which the correct estimation of the return is not possible. The profit figure used can be divisional profits before the adjustment of taxes. Again there are arguments that if the performance of the divisional manager is being assessed, the amount of profit should be “controllable profits” taking into account only the items that are under the control of the manager. Some of them suggest the use of “contribution” in place of profits. This has created a lot of problems paving the way for other forms of financial measures. Some others advocate the use of profit margin or return on sales but this too suffers from the problems relating to the definition of absolute profits. A survey conducted by Scarborough et al (1991) revealed that ‘profit’ to be the main indicator of financial performance followed by Return on sales. As per Scarborough et al, Return on investment (ROI) was the least accepted measure of financial performance. ROI is more common in the West but in Japan this measure of financial performance is practised by even less than twenty percent of the companies (Broadbent, et al., 2003, pp. 300). Cresswell and Lavigne (2003) warn that the organizations using the ROI methodology should not extend the detailed analysis beyond the requirements of making the decision. Corcoran (1997) recommendation is based on the process adopted by American Express. It requires the projects to be earmarked as required, strategic or ROI. Strategic projects enable the organizations to achieve its long term objectives. For such projects the estimation of ROI is regarded as inappropriate as such projects may not yield any significant returns in the initial years. Therefore for the strategic projects the focus must be on the intangible forms of benefits. Required projects refer to the ones that ensure the survival of the organization like the projects related to government regulations, payroll and safety. The benefits arising from these types of projects are more than obvious and so the emphasis is on maintaining cost-effectiveness. This signifies that traditional ROI assessment is not appropriate for all the projects (Guerra-López, 2008, pp.62). ROI is considered as a popular financial performance measure in United Kingdom. This can be explained by various factors. As this method is simple to understand it is most popular among the divisional managers. This is computed as a ratio and hence facilitates cross comparisons across the divisions as well as companies. This method overcomes one of the basic limitations of Residual Income (RI) which favours large sized divisions in terms of performance. As per RI the income prospects of large divisions is also higher. ROI being a ratio is not biased towards the large divisions. This measure focuses on the profits as well as assets. However the ROI is not devoid of limitations. The divisional manager is expected to improve or maintain ROI target. This can be done by replacing the assets and does not provide any impetus to the manager to increase the size of the division. In the estimation of ROI, Woodward (1991) has highlighted the problems associated with the definition of profit. In the asset base the use of historical cost, appraised value or “net book value” is debatable. The treatment of the shared assets between the divisions is also not clear. There are doubts about the ‘period’ of investment base as well with respect to the opening figure, end of year figure or an average figure. Even there are issues regarding the ‘profit’ to be used. As there are various definitions of profits care must be taken while making comparisons. It is possible that one division or company uses the after-tax measure whereas the other may use the pre-tax measure. In such situations the division using the post-tax figures will exhibit a lower return on investment whereas the other division using the Earnings before interest and taxes (EBIT) will show a higher return. To facilitate inter-comparison it is vital that necessary adjustments are made relating to taxes otherwise this traditional financial measure will fail to depict the true financial picture. It has also been seen that the divisional managers negate the projects that are in the best interest of the company. They reject the projects generating positive net present value (NPV) as they feel that this will impact the ROI of the division. Thus the use of ROI encourages dysfunctional decisions. With each divisional manager focused on the performance of the sub-unit there is no congruency of goals in the organization. ROI is said to give importance to short term goals and ignore the long term prospects of the organization. The projects that retard the short term performance are put on hold by divisional managers. This ignores the multiple objectives guiding the organization and the sub-units that may not be measurable in financial terms. Using only one measure of financial appraisal results in dysfunctional behaviour towards the other objectives. These objectives relate to growth in sales, increase in market share, improving quality etc. One way of mitigating the dysfunctional effects arising from the excessive reliance on traditional financial measures is to complement them with certain non-financial measures which are crucial for the long term profits and success of the business. The performance measures supporting the competitive strategies and objectives of the company must be developed. Traditional measures of financial performance must be looked upon as one among the various set of measures used for the controlling and measuring the divisional performance. Studies have highlighted the increasing adoption of non-financial measures of performance evaluation. This has been corroborated by literature that suggests that the non-financial measures are better indicators of long term performance as compared to the traditional financial measures. It is because the former shifts the focus of the managers on the long term business prospects. Fruhan (1979, 1984) and Stewart (1991,1994) are of the view that Excess Market Value (EMV) and Economic Rent (ER) are better indicators of performance as compared to traditional measures. Traditional or accounting measures include Earnings per share (EPS), return on investment (ROI) return on assets (ROA) and return on equity (ROE). These financial measures focus on the predictions based on the current financial position exhibited in the financial statements. But these measures fail to consider the fact that a major portion of the value of the company arises from the growth potential. EMV refers to the market value of the company in excess of the funds extended by the investors. ER or economic rent is another economic measure that represents the economic profit created by the company from the business activities. This profit differs from accounting profit in the sense that it takes into account the opportunity cost of capital as well. Companies that are able to create ER earn higher profits as compared to the others exhibiting the same risk. Both EMV and ER have found strong support from ‘Stern Stelwart Financial’, an investment company, as a financial performance measure. The financial company developed proxy names for EMV and ER. EMV is referred as Market Value Added (MVA) and ER as Economic Value Added (EVA). An examination by Fruhan (1979) revealed that the companies with high “return on equity” and with strong investment potential exhibit a higher market value. However the companies earning higher accounting returns on equity may not necessarily create value (Torrez, et al., 2006). Various empirical studies conducted over the years in US and later in other international markets have tried to answer the questions as to whether the modern performance measures like MVA and EVA are better as compared to the traditional measures of financial performance. But the results are reported to be mixed as well as controversial. The capital markets assumed a global outlook towards the beginning of 1980s. This global dimension made the investors more sophisticated as they wanted to know all probable financial details of the company. Their analysis was not limited to the financial statements like balance sheet and income statements. Cash flows have become an important measure. The reliability of earnings came under conflict. Rappaport (1981; 1986; 1998) was of the view that any real changes in the economic value cannot be measured by earnings. For overcoming the shortcomings of earnings based measures modern performance measures have been proposed by the scholars. Like the Shareholder Value (SVA) approach that discounts the estimated future cash flows to value an investment. While studies conducted by Stewart et al have proved that EVA is superior, others like Biddle et al provide contradicting results (Maditinos & Sevic, 2005). It is argued that the return on investment and earnings per share do not depict the true cost of capital. This fails to show if the company has created any wealth for the shareholders. Value creation or destruction is evident from the EVA or the excess value created by the company over the cost of capital. It is also believed that the return on investment approach is more short term based whereas EVA considers short term as well as long term benefits for the company. EVA enables the managers in identifying the improvement opportunities thus facilitating better business decisions. The growth in future value of the business is indicated by EVA; thus assessing the quality of decisions made by the managers. A higher EVA in a year indicates that the managers are using the allocated funds more efficiently thus creating additional value for the company. This too like return on investment is computed by extracting the necessary data from the financial statements. But EVA alone is not adequate for evaluating the progress of the company in the achievement of strategic goals. During inflationary periods the results of EVA get distorted failing to give the correct estimate of profitability. In times of inflation it becomes difficult to estimate the future cash flows thus impacting the measurement of financial performance (Paula & Elena, n.d.). Strengths of ROI The growing complexity of the business processes has enhanced the need for performance measures within the organization. Parker is of the view that the organizations should shift from the profit-based measure of a single division to a wide range of performance measures. According to him the return on investment must be supplemented by additional measures. Like the ability of the financial management can be assessed by turnover ratios such as asset and stock turnover, fund application and their sources, gearing ratios, maintenance expenditure of the fixed assets including policies relating to depreciation. Earnings before interest and tax per employee supplement the traditional financial measure. This shows the amount of profit earned on a per employee basis thus showing the contribution generated by each employee. The marketing performance of the company can be assessed through volume of sales, market share and other indicators like rise in the number of customer visits. A rise in the volume of sales signifies efficient marketing performance. Similarly, a rise in the market share of the company means that the company is able to cater to a large customer base. This exercises a positive influence on the business earnings thus raising the return generated on the invested capital. The balanced scorecard acts as complementary to the financial measures. Return on investment is widely accepted as a financial performance measure in small as well as large sized corporations. There have been various claims that EVA is a better than indicator of financial performance. A survey conducted by Dodd and Chen shows that the co-relation between EVA and share returns is not as high as the co-relation between the return on investment and share returns. However the co-relation found for other financial measures like ROE and EPS was low. This may be because the return on investment being a wide-ranging measure is influenced by any changes to the financial position of the company. For this reason the managers are encouraged to observe the relationship between sales, expenditures and investments. Managers are careful to maintain or improve the ratio of cost to sales thereby pushing up the profitability of the company. As the performance of the business can be easily assessed on the basis of earnings generated on the amount of assets deployed or capital invested, the managers are attentive towards earnings maximization opportunities. As the managers are accountable for the assets or divisional resources under their control they try to maximize the utilization of the asset base resulting in improved asset turnover ratios. Higher turnover means raised business earnings thereby raising the operating income of the business. The return generated by the company over the years can be compared to identify any corrective action. By way of this the divisional managers can know about the improvement in their performance. With the realization that better asset utilization will yield better financial performance the managers try and maintain optimal asset utilization. This means that the management can devote the additional resources towards the acquisition of new investments (Polimeni, et al., pp.174). Additional investments once again raise the earnings prospects of the business thus improving the overall financial position of the business. As the performance of the manager can be easily assessed from the returns generated by their respective divisions making each one of them accountable for the divisional performance they are tempted to use more cost-effective ways for raising their divisional performance. This is a good sign as it helps the company management to exercise control over the unnecessary expenses thereby making the profits soar. A rise in the profit is reciprocated by a rise in the share price of the company. The investors view this as a sign of value creation and respond by a sharp hike in the share price. The business becomes attractive to new investors as they base their decisions on the return generated by the company over the years. A rise in the historical returns of the company makes it a good investment proposition. Unlike the forecasted cash flows that get distorted by an inflationary trend thus failing to give a true picture of business profitability the return generated on investment is based on historical statements thus presenting an accurate picture of the existing affairs of the company. As the managers realize that any unutilized assets will lower their return potential they are cautious about making excessive investments in the operating business assets. This leads to lesser accumulation of stocks and debtors as the managers direct their efforts towards faster conversion of stock into sales and freeing up the funds tied in the form of debtors. This provides the company with more resources that can be effectively employed in other lucrative investments which in turn raises the value of the business. So the return generated on investment act as important indicator of the financial strength of the business. Weakness of ROI The divisional performance as indicated by return on investment brings in divisional accountability however; it makes the managers concentrate their efforts on the performance of their respective division instead of focusing on the overall performance of the company. This leads them to take the decisions that may not be in the best interest of the company. Like in order to maintain or improve the return of their respective division they may resort to stalling the investments that may not be immediately profitable but may prove to be important from the long term growth perspective. It has often been seen that the managers compromise the long term business success for achieving the short term goals. Like they often forego profitable business projects just to maintain the stability in the return generated by their division. This is because the investment initially may not be profitable and as it will comprise a significant portion of the assets base there will be a reduction in the return ratio. Many companies do not procure spare parts from external sources rather they have their own units that manufacture these parts. But often these sub-units function as a separate entity thus creating problems relating to transfer pricing of goods. In order to show higher returns for their respective units they charge higher prices from the other units for transferring the semi-processed products thus overlooking the main aim of creating such a unit. The bid to show higher returns encourages the sub-units to charge higher prices for the internal transfers within the organization. This is a blow to the ultimate purpose of creation of such a sub-unit. But to satisfy the financial measure such as generating higher return on investment the managers indulge in these practices. The performance in this regard should be measured on a different basis like supplying the semi-finished good at less than the prevailing market price; otherwise there is no incentive in manufacturing the goods internally. The other hurdle in the return on investment concept is the dearth of business acumen. Merely telling the manager to raise the return is not sufficient. They may not follow a constructive and fair way of raising the same. It is possible that the manner in which they raise the return is not consistent with the strategy of the company. The actions taken by them may increase the returns in the short run but go against the interest of the company from the long term point of view. Like to scale down costs the managers may resort to cutting down on research and development expenses. The expenses relating to research may be high initially but are crucial as it helps the company to produce sophisticated products and services. In the absence of a developed research unit the company may not be able to prosper in the long run. The method of performance measurement through generated returns may not be fair for some of the managers who inherit the business segment that involve committed costs that are not under their control. These costs are important from the overall viewpoint of the business but come in the way of a fair assessment of the manager with respect to his other counterparts. Like evaluating the performance of a sales manager on the basis of return generated is unfair. The ROI of his division is sensitive to selling price and volume. However the sales manager does not have nay control on either of the factors. Both price and volume are market driven and cannot be controlled by any individual. For instance the sale of two-wheelers is influenced by economic conditions which are beyond the control of the divisional manager. Another argument that goes against the performance evaluation based on return is that the decisions made by the divisional manager merely increase the divisional return on investment. Savings generated by cutting down the necessary costs may boost the returns temporarily but damage the image of the company in the long term. This includes lapses in the maintenance, overburdening the employees to raise productivity levels etc. Conclusion From the above analysis it is clear that evaluating divisional performance on the basis of ROI diverts attention from the overall business objectives. It becomes a major hurdle to congruence of goals within the business set-up. With each divisional manager engrossed in sweetening the performance of his division; the ultimate business objective is lost. ROI encourages the divisional managers to chase short-term business goals at the expense of long term profitability. It narrows down the objectives of the business (Hansen & Moyen, 2006, pp.435). This shows that the traditional measures of financial performance cannot itself be accepted as a measure of evaluating divisional performance. Rather this should be supplemented by other “non-financial” measures like productivity, quality, competitiveness, innovation, product leadership and flexibility towards the market demand. For appraising divisional performance the company must rely on a combination of financial as well as non-financial measures like balanced score-card (Burkšaitienė, 2008). ROI is criticised on the ground that it focuses on raising the ratios without any effort to improve the absolute profits. Some writers suggest that ROI presents a narrow picture of performance. According to Parker, keeping in line with the plurality of business objectives it is important to have a balanced approach of performance evaluation. This view has been seconded by Kaplan and Norton (1992) who devised the measure of balanced score-card facilitating a fast and comprehensive view of business performance (Broadbent, et al., 2003). This will lead to realization of the basic business objectives like growth in sales, enhancing market share etc. It will help in enjoying the merits of the traditional financial measures without foregoing business opportunities. ROI if used in alliance with the other non-financial measures offers a mechanism of finding the quantitative ability of the human resources. It also helps in allocating the resources in a more competitive way (Rachlin, 1997, pp.225). As ROI is computed as a ratio it is not biased towards the large divisions thus overcoming one of the limitations of financial appraisal. If executed properly it can make the divisions more responsible and accountable for their performance. As the managers know that their performance will be monitored and compared they give in their utmost towards cost control. But here again it must be remembered that there are certain areas that remain out of the purview of the divisional managers. Like the performance of the sales team is affected by the market conditions, that are cyclical in nature. Therefore it is possible that the manager of this division may not be able to maintain a consistent performance. Keeping in mind the uncontrollable factors it is important that the performance of these managers is evaluated with the competitors. The concept of return on investment ensures that the assets are utilized to their full capacity resulting in optimal use of available resources. This results in higher turnover ratios. A high inventory turnover ratio ensures that the company’s funds do not remain blocked for long and fast debtors realization ensures improved liquidity. The requirement of maintaining high return ratios incentivize the managers to maintain optimal turnover ratios. All this shows that the use of traditional financial measures have their own set of advantages and for better results they should be used as complementary to the other non-financial measures. Reference Broadbent, M. Broadbent, M. Cullen, J. 2003. Managing financial resources. Butterworth-Heinemann. Burkšaitienė, D. 2008. DEVELOPMENT OF DIVISIONAL PERFORMANCE MEASURES. Vilnius Gediminas Technical University. Available at: http://www.vgtu.lt/leidiniai/leidykla/BUS_AND_MANA_2008/fin-engeneering/164-172-G-Art-Burksaitiene.pdf [Accessed on June 29, 2010]. Guerra-López, I.J. 2008. Performance Evaluation: Proven Approaches for Improving Program and Organizational Performance. John Wiley and Sons. Hansen, R.D. Moyen, M.M. 2006. Managerial Accounting. Cengage Learning. Maditinos, I.D. Sevic, Z. 2005. Literature review. Performance measures: Traditional accounting measures versus modern value-based measures. Available at: http://www.teikav.edu.gr/abd/articles/ICAFT_05_EVA_EPS_Greenwich.pdf [Accessed on June 29, 2010]. Maguire, D. Kouyoumijan, V. Smith, R. 2008. The Business Benefits of GIS: An ROI Approach. ESRI, Inc. Paula, A.D. Elena, C.D. No date. The calculation of EVA and MVA and the link between EVA and MVA. EVA VERSUS TRADITIONAL ACCOUNTING MEASURES OF PERFORMANCE AS DRIVERS OF SHAREHOLDER VALUE – A COMPARATIVE ANALYSIS. Available at: http://www.upm.ro/proiecte/EEE/Conferences/papers/S309.pdf [Accessed on June 29, 2010]. Polimeni, S.R. Handy, A.S. Cashin, A.J. 1994. Schaum's outline of theory and problems of cost accounting. McGraw-Hill Professional. Rachlin, R. 1997. Return on investment manual: tools and applications for managing financial results. M.E. Sharpe. Torrez, J. Al-jafari, M. H Juma’h, A. 2006. Growth Potential Measures of Value. CORPORATE VALUATION: A LITERATURE REVIEW. Vol. 2 No. 2. Available at: http://ceajournal.metro.inter.edu/fall06/torrezetal0202.pdf [Accessed on June 29, 2010]. Bibliography Alonso, G. Dadam, P. Rosemana, M. 2007. Business process management: 5th international conference, BPM 2007, Brisbane, Australia, September 2007 : proceedings. Springer. Burbage, M.G. No Date. SEGMENT REPORTING AND DECENTRALIZATION. Available at: http://wserver.scc.losrios.edu/~burbagg/notes-c12.pdf Lipe, G.M. Salterio, E.S. 2000. The Balanced Scorecard: Judgmental Effects of Common and Unique Performance Measures. Available at: http://pcbfaculty.ou.edu/classfiles/ACCT%205970-JDM%20in%20Accounting/Readings/lipe%20salterio%202000%20AR.pdf Philips, J.J. Philips, P.P. 2001. Measuring return on investment, Volume 3. American Society for Training and Development. University of Central Florida. Cost Management: A Strategic Enterprise. Available at: http://www.bus.ucf.edu/ajudd/Managerial%20Accounting/Chap018.ppt#9 Read More