Q. Show the Demerits of using return on investment?
The following disadvantages maybe experienced when choosing to use ROI as a primary performance measure.
- An accounting not cash-based measure. A company with old noncurrent assets that are almost completely depreciated will show a high ROI/ROCE, whereas a company with recently acquired noncurrent assets will show a low ROI/ROCE. Different accounting policies will also give different ratios, for example using the historical cost model or re-valuation model to measure capital employed, also different stock valuation or depreciation policies can materially affect the size of capital employed.
- The age of (or investment cycle) of non-current assets is important in understanding the ROCE/ROI ratio. Recently acquired noncurrent assets will not be generating revenues to their full extent. ROCE/ROI can act as a disincentive to invest by a manager, because new investment often delivers low profitability and high accounting book value, in the early years of investment. This can discourage managers in the short-term from undertaking investment because a low ROCE/ROI will be harmful to their performance measurement. The long-term effect is goal incongruent decisions being made e.g. investment which is essential maybe delayed, the long-term consequences inefficiency and higher cost in future.
- Such methods can create short-term behaviour by divisional managers. Under investment in non-current assets causes the accounting net book value to decrease over time. If profits remain fairly static in the short-term, ROCE/ROI will improve, yet the manager has done very little in terms of improving performance. ROCE/ROI improves over the life of an asset where little or no reinvestment has taken place. Managers may also be over zealous when cutting back expenditure in order to improve profit e.g. Cutting back on advertising, staff training etc., such rationalisation programmes can jeopardise the long-term profit of the business.
- ROI may create political arguments over such costs as head office apportioned overhead or interest charges by head office that have negative impact on ROCE/ROI. "Controllability principle" is concerned with assessing performance based upon measures which can be controlled only by a manager and neglecting any items which are uncontrollable.