Fictional performance and incentives
A fictional division has operating profit 180 and invested operating assets 1000. Its required capital charge is 12 percent in this simplified model. Management offers another project requiring 200 additional assets and generating 30 additional annual operating profit with comparable risk and consistent measurement. The division manager is rewarded solely for increasing its average ROI and therefore objects to the new project. A board member believes any objection proves dishonesty, while another suggests replacing every financial indicator with training hours. The task is to calculate the incentive conflict and propose proportionate evaluation. All numbers are fictional and no financing, tax or accounting policy change is assumed. Real implementation would also examine service quality, timing, capacity, uncertainty and who can influence each result.
1. How do ROI and residual income compare?
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Existing ROI=180/1000=18 percent. Combined ROI=210/1200=17.5 percent, while residual income rises from 180−120=60 to 210−144=66.
2. Why might the manager reject a value-adding project?
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A sole average-ROI incentive can discourage a project yielding 15 percent when the existing average is 18 percent, even though it exceeds the 12 percent capital charge. Use consistent complementary measures and investigate behavior without assuming fraud.