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# Issues of using ROI as performance evaluation tool

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Jennifer Baskiter is president and CEO of Plants& More.com , an Internet company that sells plants
and flowers. The success of her startup Internet company has motivated her to expand and create
two divisions. One division focuses on sales to the general public and the other focuses on
business-to-business sales to hotels, restaurants, and other firms that want plants and flowers for
their businesses. She is considering using return on investment as a means of evaluating her divisions
and their managers. She has hired you as a compensation consultant. What issues or concerns
would you raise regarding the use of ROI for evaluating the divisions and their managers?

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Dear student,

Solution attached. I have answered the question generally using my own words and hence reference not quoted.

E25.6
Jennifer Baskiter is president and CEO of Plants& More.com , an Internet company that sells plants
and flowers. The success of her startup Internet company has motivated her to expand and create
two divisions. One division focuses on sales to the general public and the other focuses on
business-to-business sales to hotels, restaurants, and other firms that want plants and flowers for
their businesses. She is considering using return on investment as a means of evaluating her divisions
and their managers. She has hired you as a compensation consultant. What issues or concerns
would you raise regarding the use of ROI for evaluating the divisions and their managers?

Solution:
Return on investment is a profitability measure and also being used as a performance measure for managers. Return on investment denotes the returns earned as a percentage of total investment.
This ratio can be computed as follows:
Return on Investment (ROI) = Net income/Average investment
If ROI is calculated for a company's division, then ROI = Division's net income/Division's investment.
I would raise the following issues and concerns regarding the use of ROI for evaluating the performance of the divisions and its managers:

ROI: Short-term in focus and decision making when used as a performance measure
ROI as a performance measure is purely based on profitability and does not aim at wealth creation. Higher the profits are shown, higher would be the ROI. Profits can be manipulated in many ways. A manager may increase the volume of credit sales without being concerned about bad debts expense and investment in accounts receivable, just to show increase in revenue and profits. This may result in more uncollectibles and implied interest cost for the company for cash blockage in receivables. The focus for the manager here is short-term, just to improve revenue for the period, without considering the long-term effects of such decisions. The problem of uncollectibles will not occur immediately in the short-term but in the long-term. But at the same time the manager would also be concerned about investment in receivables as this is going to increase the investment amount in the denominator. The manager may also postpone some expenses to show higher profits. For example, if performance is measured based on ROI, the manager may be induced not to show the utility cost bills that arrived at the end of the accounting period. This explains the nature of short-term focus.
Although ROI has advantages, it suffers from the following limitations:
1. Any profitable project would be rejected by the managers for want of increased investment. This is because increased investment would reduce the ROI in the initial stages which would lower their pay.
2. It is not as efficient way as EVA as it does not cover all the aspects of business cycle.
3. Increase in ROI is not necessarily good for the owners or the shareholders. Maximizing ROI alone cannot be the goal or target for operating business.
4. ROI is a problematic controlling tool and cannot be relied always.
5. Evaluation using ROI can lead to under-investment.
6. Focused in short-term decision making and not long term.

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