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Two of divisonal managers in Wilow co disagree on performance measure which should be used to determine their bonus for the year. Manager 1 is manager of a large division while manager 2 is manager of small division. Manager 1 prefers to use RI and has given following examples of limitations of ROI to support this decision.
a) ROI can overemphasis short term performance at expense of long term performance
b) If assets are valued at NBV, ROI figs generally improve as assets get older. This can encourage managers to retain outdated plant & machinery
c) ROI is a relative measure therefore small investments with high rate of return may appear preferable to a larger investment with lower ROI. However larger investment may be worth more in absolute terms
Sir here c) is correct ans but please can you explain that why it is correct and why a) and b) are wrong because I have read that ROI can encourage short termism and it increases as asset gets older thus giving managers incentive to hang onto inefficient machines
To explain why (c) is correct, imagine you had the choice of investing $10 that gave a return of 10% or alternatively investing $100 and getting a return of 9%.
Although the first choice gives a higher % return, it is the second choice which would end up giving you more cash.(a) is wrong because both ROI and RI are measured over the short term.
(b) is a limitation of ROI for exactly the reason you have stated.
Sir as you said that b) is the limitation of ROI due to reason I have stated then why it is not the correct answer?
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