Honiara Ltd made a capital investment of $100,000 in new equipment for its Sandman Division two years ago. The analysis at that time indicated that the equipment would save $35,000 in operating expenses per year over a five-year period. Discounted cash flow methods were used to evaluate the proposal. Before the purchase, the division ROI was 20 per cent.
Timothy Williams, the division manager, believed that the equipment had lived to its expectations. However, the divisional performance report showed that the overall return on investment for the first year in which the equipment was used was less than that in the previous year' Williams asked the Counting Department to break down the figures related to this investment to find out why it did not contribute to improving the division's ROI.
The Accounting Department was able to identify the equipment's contribution to the division's operations. The report presented to the division manager at the end of the first year is as follows:
Reduced operating costs due to new equipment.................$35,000
Less Depredation, 20% of cost.......................................20,000
Contribution...........................................................$15,000
Investment, beginning of year......................................100 000
Investment, end of year...............................................80,000
Average investment for the year.....................................90,000
ROI = 15,000 / 90000
= 16.7%
Timothy Williams was surprised that the ROI was so low, because the new equipment performed as expected. The staff analyst in the Accounting Department replied that the ROI used for performance evaluation differed from the methods used to evaluate capital investment proposals.
Required:
1. Explain why the new equipment has not resulted in the expected improvement in financial performance.
2. Discuss the behavioural problems that can be associated with using ROI as a divisional performance measure. What might Timothy Williams do the next time a new equipment purchase is proposed?