Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of Performance Evaluation:

Learning Objectives:

1. What are the limitations of return on investment method of performance evaluation?

Although the return on investment is widely used in evaluating performance, it is not a perfect tool. The method is subject to the following criticism:

1. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company’s strategy; or they may take actions that increase ROI in the short run but harm company the long run (such as cutting back on the research and development). This is why ROI is best used as part of a balanced scorecard. A balanced scorecard can provide concrete guidance to managers, making it more likely that action taken are consistent with the company’s strategy and reducing the likelihood that short-run performance will be enhanced at the expense of long-term performance.

2. A manager who takes over a business segment typically inherent many committed costs over which the manager has no control. These committed costs may be relevant in assessing the performance of the business segment as an investment but make it difficult to fairly assess the performance of the manager relative to other managers.

3. A manager who is evaluated based on return on investment (ROI) may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager’s performance evaluation.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

1. Decentralization in organizations
2. Traceable and common fixed costs
3. Segment reporting and profitability analysis-segmented income statements
4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
5. Segmented Financial Information on External Reports
6. Return on Investment (ROI) for Measuring Managerial Performance
7. Controlling and Improving Rate of Return on Investment
8. Return on Investment (ROI) and Balanced Scorecard
9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
10. Residual Income-Another Method to Measure Managerial Performance
11. Limitations, Criticism or Disadvantage of Residual Income Method
12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
13. Set transfer prices at cost using variable or full (absorption) cost
14. Set transfer prices at the market price
15. Divisional Autonomy and Sub optimization
16. International Aspects of Transfer Pricing

Other Related Accounting Articles:

• Return on Investment (ROI) and Balanced Scorecard
• Limitations, Criticism or Disadvantage of Residual Income Method
• Set Transfer Price at Market Price
• Transfer at Cost to the Selling Division
• Segmented Financial Information on External Reports
• Residual Income-A Method to Measure Managerial Performance
• International Aspects of Transfer Pricing
• Methods of Controlling and Improving the Rate of Return on Investment (ROI)
• Traceable and Common Fixed Costs
• Divisional Autonomy and Sub-optimization