Problems with Evaluating Performance

ROI is not a guaranteed measure of performance. Managers learn what elements

are used in its calculation and make special efforts to maximize the measure's
outcome so that they will rewarded. There are two major problems with
performance evaluation--overinvestment and underinvestment. Both exist because
managers often exhibit goal incongruence---they act in their own interest rather
than the best interest of the company.
Overinvestment
When managers are evaluated in terms of only profit, they may be motivated
to overinvest. Their goal is to increase profit. Profit can be increased by investing
in new projects that carryany rate of return, including a rate that is less than the
minimum required rate specified by management. The focus on profit causes
managers to accept investments which earn less than the required rate of return
solely to increase profit.
Take for example a proposed investment of $10,000 with an expected ROI of 5%,
and a required rate of return of 12%. The manager should not invest because the
investment is expected to generate a return less than the minimum 12% return
specified by top management. However, because this investment will increase
profit by $500 (5% of $10,000), the segment manager will likely invest without
regard to the required rate of return. Why? If the manager is evaluated on profit, he
will be motivated to make himself appear to be performing well by increasing
profit.
A solution to the overinvestment problem is to use ROI for performance
evaluation. ROI adds an evaluation factor that requires profit to be a percentage of
the invested assets.
Underinvestment
An investment center's manager that is evaluated using ROI may be motivated
to underinvest. If an investment center has a high ROI, the manager will be
motivated to turn down projects that dont increase ROI, even though certain
investments may earn a return that exceeds the required rate of return. Managers
turn these projects down because these investments reduce the investment center's
overall ROI in the short-run causing the manager to appear to be performing
poorly.

For example, assume a segment manager is debating the purchase of a machine

costing $10,000 with an expected ROI of 12%. Top level executives have specified
a required rate of return of 10%. Two actions by the divisional manager are
possible. First, the manager may accept the investment because he should accept
all investments that exceed the minimum required rate of return. If accepted, the
division's overall ROI will drop due to the operations pertaining to the new
machine being combined with the existing 12% return.
Second, the manager may reject the investment because he does not want to lower
his divisional ROI, which would cause him to look as if he is performing poorly.
What the managershould do is accept the investment. What the manager will most
likely do is reject the investment. A manager that rejects the investment is
exhibiting goal incongruence as he is acting in his best interest rather than the
company as whole.
Managers typically figure out that when new assets are acquired, the additional
cost of the new assets causes the denominator---invested capital---to increase,
which in turn, decreases ROI. Because managers do not want ROI to appear to
drop, they often defer new equipment purchases. However, failing to acquire new
equipment typically has a negative impact on the company's performance in the
long run as the company becomes less competitive.
Comparing ROIs
Because assets are carried in the accounting records at historical costs, it is difficult
to compare one company's ROI with another company's ROI. This is because older
assets typically have smaller book values than assets acquired more recently.
Companies with smaller book values have higher ROIs than companies with larger
book values, even if the assets are similar in original costs.