Answer to Question #127095 in Accounting for Relebogile

Question

Explain the marits and problems of using the return on investments, residual income and the economic value added methods

Answer 1

the marits and problems of using the return on investments:

the marits:

• the best unit of measure for profitability - links net income and investments
• achieving the ultimate goal of the company - each increase in the profitability of divisions leads to the achievement of the final goal
• comparative analysis - the ability to compare different companies, divisions, etc.
• efficiency of the investment department - assessment of the performance - the return on investments
• some other performance indicators - efficient use of fixed and working capital, equity
• all data for calculation in financial statements

 problems:

• various types of profit and investment, sometimes it is difficult to understand which ones to choose for analysis
• when comparing companies, it is necessary to have the same accounting policies, which is not always the case
• only for calculating short-term results, long-term results are not considered
• the staff of the investment department can change the indicators of accounting policy, this is lost transparency, the possibility of data distortion

the marits and problems of using the residual income:

the marits:

• easy to convince managers to raise new investments
• the minimum rate of return varies with the riskiness

 problems:

• difficult to analyze performance between departments
• residual income grows with decreasing investments and costs, managers reduce R&D costs
• managers set even lower profit margins

the marits and problems of using the economic value added methods:

the marits:

• comprehensive analysis, including data from other assessment methods
• shows the availability of working capital after deducting its value
• it is an indicator of the motivation for the future activities of the company

 problems:

• does not determine the efficiency of using retained earnings
• does not calculate the return on development and research

Each method has its own advantages and disadvantages. Managers need to use them depending on the situation: either for the short or long term, or look at the balance of all deductions in general.