If it is the performance of the investment centre that is being assessed, however, the inclusion of general service and head office costs would seem reasonable. The profit figure for ROI should always be the amount before any interest is charged. 1.5.2 Shortcomings of ROI a) Ignoring time value of money ROI ignores the time value for money. The concept of time value for money is that the value of money changes over time i.e. the value of a dollar / pound today is different from the value of a dollar / pound tomorrow and accordingly the purchasing power of the same unit of money undergoes a change. b) Ignores risk associated with the project ROI also ignores the risks associated with the project. Therefore, while taking a decision regarding projects with different levels of risk, using ROI may result in ignoring a good project which has less risk and accepting a project with high return and corresponding high risks. c) Flexibility It is good that ROI can be modified to fit the situation. However, this advantage becomes a disadvantage when the flexibility is used to manipulate the results so that they are expressed in a different way. d) Inconsistency The terms income and investment can be interpreted in various ways. Income is sometimes taken as before interest and tax; sometimes as after interest and tax. Likewise, investment also sometimes considers net assets and, sometimes, the gross value of assets. e) Short-term analysis The calculation of ROI takes into consideration short-term investments only. Long-term costs such as maintenance, software upgrades etc. are ignored. Therefore, projects with heavy long-term costs may show a high return on investment in the initial period of time. f) Variation in calculations If the depreciation calculation methods are different for the different units, it is difficult to compare their performances. 1.6 Residual Income An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost. (a) The centre's profit is after deducting depreciation on capital equipment. (b) The imputed cost of capital might be the organisation's cost of borrowing or its weighted average cost of capital. Residual income (RI) is the operating income that an investment centre is able to earn above a particular minimum return on its assets.
If it is the performance of the investment centre that is being assessed, however, the inclusion of general service and head office costs would seem reasonable. The profit figure for ROI should always be the amount before any interest is charged. 1.5.2 Shortcomings of ROI a) Ignoring time value of money ROI ignores the time value for money. The concept of time value for money is that the value of money changes over time i.e. the value of a dollar / pound today is different from the value of a dollar / pound tomorrow and accordingly the purchasing power of the same unit of money undergoes a change. b) Ignores risk associated with the project ROI also ignores the risks associated with the project. Therefore, while taking a decision regarding projects with different levels of risk, using ROI may result in ignoring a good project which has less risk and accepting a project with high return and corresponding high risks. c) Flexibility It is good that ROI can be modified to fit the situation. However, this advantage becomes a disadvantage when the flexibility is used to manipulate the results so that they are expressed in a different way. d) Inconsistency The terms income and investment can be interpreted in various ways. Income is sometimes taken as before interest and tax; sometimes as after interest and tax. Likewise, investment also sometimes considers net assets and, sometimes, the gross value of assets. e) Short-term analysis The calculation of ROI takes into consideration short-term investments only. Long-term costs such as maintenance, software upgrades etc. are ignored. Therefore, projects with heavy long-term costs may show a high return on investment in the initial period of time. f) Variation in calculations If the depreciation calculation methods are different for the different units, it is difficult to compare their performances. 1.6 Residual Income An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost. (a) The centre's profit is after deducting depreciation on capital equipment. (b) The imputed cost of capital might be the organisation's cost of borrowing or its weighted average cost of capital. Residual income (RI) is the operating income that an investment centre is able to earn above a particular minimum return on its assets.
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