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Hi,
Seek for your advice.
1.According to bpp book page 418, it says that unlike ROI, RI can sometimes gives results that avoid the behavioural problem of dysfunctionality. Could u pls further explain on this.
2. Are this statement relating to the alteration on the account payable and account receivable in order to get a better performane evaluation? Because I believe that this would effect both AP and AR on profit (cost of sales) and capital employed (current asset and current liabilities) as well.
ROI = profit ÷ capital employed
RI = profit – notional interest cost.Thank you.
I do not have the BPP Study Text, only the Revision Kit.
However with regard to the first statement, one problem with ROI is that the division will be motivated to do anything that increases their ROI. However that may result in them investing in projects that give a lower return than that required by the company as a whole if the division is currently underperforming. RI on the other hand allows the company to fix the imputed interest at the rate the company requires and the division is then motivated to do what the company wants.
I do explain this, with examples, in my free lectures. The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
I do not understand your second point because without having the book I do not know what alterations they are referring to.
About the point number two; the book, says “If a manager’s large bonus depends on ROI being met, the manager may feel pressure to massage the measure. The asset base of the ratio can be altered by increasing/decreasing payables and receivables (by speeding up or delaying payments and receipts).”
The “asset base ratio” may indicate the “profit” (cost of sales) and the “capital employed” (current asset and current liabilities) as in the ROI and also RI formula. Therefore, manager can easily manupulate their performance evaluation (ROI and RI) by altering the profit and capital employed figure.
ROI = profit ÷ capital employed
RI = profit – notional interest cost.Is my understanding correct or not?
Your formulae are correct (albeit the capital employed is always equal to the net assets of the business). So manipulating the payables and receivables, and manipulating the profit are both ways in which the manager can alter the ROI.
(There is no such thing as the ‘asset base ratio’ – the statement refers to the asset base of the ratio i.e. the denominator of the ROI)
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