Week 4 summary - Advantages and disadvantages of ROI, RI and EVA - Enterprise Performance Management PDF

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Summary

Advantages and disadvantages of ROI, RI and EVA...

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Advantages of ROI:  Easy comparability with internal and external benchmarks and other divisions who use ROI.  Controls for size and differences across plants and divisions.  Reduces tendency to overinvest in project by managers (as we hold managers responsible for ROI level)  Motivates managers to increase sales, decrease costs, and minimize asset investment. Disadvantages:  Discourages managers from investing in projects that reduce a division’s ROI (even though may improve ROI of firm, or have short term negative effects for the divisions, but long term positive effects for the overall firm.  Does not incorporate measures of risk (managers may invest in riskier projects that increase ROI, but provides added risk to the entity).  Inappropriate cutting of costs which benefit the firm in the long run (R&D, employee training, etc.) to increase ROI (dysfunctional behavior).  Financial accounting causes investment in assets to be understated (especially when value of assets (such as property) has increased. This causes ROI to be overstated. Advantages of RI  Does not penalize investment in projects with lower returns than current project returns. Disadvantages of RI  Due to RI being an absolute dollar value, larger subunits will have larger RI’s, and thus it is difficult to compare performance across units.  RI increases as investment and costs decreases, so managers may cut R&D costs, and employee training costs for higher RI (sacrificing long term benefit for short term).  Incentive for managers to set lower required rate of return (and thus invest in less-profitable or less risky projects when riskier projects are profitable). Economic value added   

An investment opportunity with EVA greater than 0 will be seen favourably. Measures used for internal purposes need not follow accounting standards or GAAP. R&D costs are often capitalized for EVA calculations  This encourages managers to invest in R&D projects that have long-term value for the firm.

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Long-term leases accounted for as operating leases (under GAAP) are often treated as capital leases for EVA calculations.  Reduces manager’s incentives to use operating lease to artificially understate the entity’s investment in assets.

Advantages:

Adjustments are made to personalize the measure to each entity, and thus this can align goals of managers with owners. Disadvantages: Relies on financial accounting numbers (and thus, there is incentive to manipulate numbers to increase EVA). Overemphasizes the need to generate immediate results (short-term oriented). This creates disincentive for managers to invest in innovative products or technologies. There is a lot of judgment involved (determining cost of capital, and level of risk incorporated for each division or entity) EVA is also very complex, and is an expensive and time consuming process that is more suited to higher level organizations rather than lower levels. Does not control for size differences across plants or divisions...