Please List the Advantages and Disadvantages of Using Roi to Asses to Divisions Performance

KOZMINSKI UNIVERSITY

[Advanced Performance Management]

[Purity Steel Corporation]

Adham 34094

Alfredo

Chirag Sheth 34114

Xiaoming Zhang 34122

[Submission Date – 16-11-2017]

Academic Year 2017/2018

Semester: 1

I hereby certify that this paper is the result of my own work and that all sources I used have been reported.

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© Kozminski University 2016

1.1 Please list the advantages and disadvantages of using ROI to asses to divisions performance?

Measuring return-on-investment is one of the widely used performance measures in an investment center. The ROI calculation illustrates the relationships between the profits and the capital used to create that amount of profit in a division. The formula of ROI is: ROI= Income / Invested Capital

It can also be rewritten as ROI= (income/ invested capital) = (income/ sales revenue) x (sales revenue/ Invested capital), which is sales margin multiplied by capital turnover.

Advantages:

• Good Economic measure, easily compared between various sized divisions
• Performance and standards easily understood for non-financial managers
• Make managers pay more attention on assets used to make profit
• Highly motivational
• High levels of controllability

Disadvantages:

• Disfunctional for decision making if used for investment decisions, short-term Focus,
• Creates incentive for inaccurate financial statements
• Self interest of managers dominates decisions
• Easy to manipulate

1.2 Please refer to the compensation plan used in purity steel corporation

A successful incentive compensation plan should recognize the desired behavior that the company wants to stimulate within the managers. The current compensation plan communicates the objectives that WSD management hopes to achieve. It consists of a combination of a basic salary and extrinsic rewards. Return-on-investment is the primary source of measure for the plan.

ROI was capped at 20% and 5% was established at the floor. As a performance measure, ROI was introduced because it takes account both branch income and the capital invested in the particular branch.

Components

1. Base salary:

• Determined mostly on dollar sales volume of the district in the prior year.
• Increase in sales or profitability considered
• Established by General Manager, WSD and ranges will be reviewed periodically to keep the Division competitive with similar companies.

1. Growth Incentive:

• Is calculated as $1750 for every $500,000 of increased sales during the year.
• An advantage of a formula-based plan is that managers know exactly what the will receive.

1. Return-on-Investment Incentive:

• Measures how effectively each branch used its invested capital to earn a profit.
• Managers paid in direct proportion to their effective use of assets placed at their disposal
• Emphasis: to increase the return at any level of investment, high or low

Limitations on ROI

• No incentive paid to managers below 5% before federal taxes
• No additional incentive will be paid above 20%
• No payments will be made in excess of $50,000

Calculation on ROI incentive

• Exact incentive amounts cannot be determined if illustrated using a graph. However rough estimates can be determined (Exhibit 2)
• Exact amounts can be determined by following the steps showed in the case study

Problems with current compensation plan:

Capping the ROI amounts at $50,000 could result in branch managers not performing at their optimal levels, they will not pursue higher growth after reach the limitation

ROI is a short-term measure and is significantly influences managers to make decisions only considering short- term advantages or disadvantages, especially when making investment decisions, ROI is not a good choice.