12 IF ROI IS USED TO EVALUATE PERFORMANCE, PRICE CAN LEAD TO INCORR...

12-12 If ROI is used to evaluate performance,

price can lead to incorrect decisions. When the

a manager of an investment center may reject a

profitable investment opportunity whose rate of

selling division has idle capacity, the cost to the

company of the transfer is just the variable cost

return exceeds the company’s required rate of

of the item transferred. However, if the market

return but whose rate of return is less than the

investment center’s current ROI. The residual

price is used as the transfer price, the buying

division regards the market price as the cost. If

income approach overcomes this problem since

the market price exceeds the variable cost

any project whose rate of return exceeds the

(which will ordinarily happen), managers in the

company’s minimum required rate of return will

result in an increase in residual income.

buying division will make less than optimal pric-

ing and other decisions concerning the product.