Question

Senior management at Harriot Industries, an Italian-based fashion house and cosmetics company, have been engaged in a debate around the best key financial measure relevant to evaluate the performance of senior executives and divisional managers. Currently, the performance of senior managers and divisional managers is based on return on investment (ROI), which forms the basis of the bonus payments, provided ROI increases are achieved each year. The main source of tension seems to be that some of the accounting staff are pushing for the use of economic value added (EVA) or, at the very least, residual income (RI) to be used at both the senior executive and divisional levels. You have been asked to contribute some views. On a recent visit to the head office of Harriot Industries you were able to access details on a printout from a digital whiteboard that represented a discussion about performance measures and a potential investment project in the Logistics Division. Some of this material is provided below.

Investment project: Logistics Division $4 500 000 Project outlay NPV $1 200 000 Average ROI in first two years 10% Average ROI over project life 12% 16% p.a. Current ROI of Logistics Division Current cost of capital and hurdle rate 9%

Required

Using the information provided in the table, demonstrate the key arguments that might be put forward to support the view that the sole use of return on investment (ROI) may be inappropriate, particularly at the divisional level.

Answer 1

It is true that sole use of ROI i.e, Return on investment is not appropriate particularly at the divisional level.The arguements in support of this are as follows:-

(1)As given in question that current ROI of logistics division is 16% and the ROI in proposed project is less than 16% and bonus of divisional managers is based on ROI i.e, if ROI increases they will get the bonus.

Now because of this ,Divisional manager of logistic division will oppose this project because it will affect his bonus as ROI on proposed project is lesser than previous ROI.

But if we look on the part of company ,ROI is greater than hurdle rate which is 9%.

So In this case conflict of interest will arise as company would like to accept because it will add value but manager will oppose because it will affect his bonus.

So we can say that solely using ROI creates conflict of interest and does not align the goals of company and manager i.e,What is good for company is not good for manager and vice versa.