Effects of Price Level Changes on ROI and RI

The price level changes are a common phenomenon and will introduce entirely new distortions into ROI and RI measures. The principal distortions occur because revenues and cash costs are measured at current prices, while the investment cost and depreciation charge are measured at historical prices used to acquire the assets. Depreciation   based on historical cost underestimates what the depreciation charge would be based on the current cost. This results in overstating the firm’s income. At the same time, the firm’s investment is understated, because most of firm’s  assets  were  acquired  in precious years at lower price levels than those currently prevailing.  The combination of overstated net income and understated investment causes the ROI or RI measures to be much higher than if inflation had not occurred. The increased ROI or RI is not a signal of higher profitability and it is mainly due to a failure to adjust for inflationary’ effects. But when the adequate or satisfactory returns are caused by under-depreciation of older assets and the failure to restate investment in terms of current cost, firms will find that new investment at the current price level yields less than satisfactory return. And divisions with new assets will tend to show lower ROI and RI measures than divisions whose assets were acquired at lower price levels.  Unless some adjustment is made to eliminate such inflationary effects, managers will be reluctant to make new investments because of the negative impact on their ROI and RI.

A simple adjustment will remove much of the inflationary effects from ROI and RI measures. The simplest way to perform the adjustment to current cost is to use an index specific to each asset class, a number of indices for specific class of assets are published by the Government and trade associations. But these specific indices fail to reflect the changes technological developments. Hence, measurement of current value can be decided by independent appraisal or by making comparisons to the selling prices recently traded comparable assets. In making these   adjustments, it is important to use an objective method, such as indexing. The objective for making inflation, adjustments must be to prevent enormous distortions in the evaluation of investment center performance. Index methods, either general or will provide a good basis for making adjustment for inflation while programming the objectivity and for manipulation necessary for a system of divisional performance rationally. Index methods are the least expensive for usage. One more item is the effect of inflation on the cost of which will lower the future value of real rate of return. The cost of therefore, is a function of anticipated inflation so that companies should a fixed target rate for divisional ROI or to compute capital changes for measure. Necessary adjustments to the divisional cost of capital must  be done as part  of either the capital  budgeting  process or performance evaluation measure.