Briefly discuss the strengths and weaknesses of ROI and Rl as methods of assessing the performance of divisions.
ROI is expressed as a percentage and is more easily understood by non-financial managers.
ROI can be used to compare performance between different sized divisions or companies.
It is not necessary to know the cost of capital in order to calculate ROI.
ROI may lead to dysfunctional decisions. For instance, if a division has a very high ROI of say 40% and is considering a project with an ROI of 30% which is still well above the cost of capital of say 10%, then the project should be accepted as it provides a return well in excess of the cost of capital. The division may quite possibly reject the project, however, as when added to its existing operations it will reduce the ROI from 40%.
Using residual income as a performance measure should ensure that divisions make decisions which are in the best interests of the group as a whole and should eliminate the problem outlined in the previous paragraph.
Different divisions can use different rates to reflect different risk when calculating residual income.
Residual income is not useful for comparing divisions of different sizes.
Both residual income and ROI improve as the age of the assets increase and both provide an incentive to hang onto aged possibly inefficient machines.
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Explain what is meant by a standard cost
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