Divisional performance and investment measures - Advantages,...

Learning Outcomes

By the end of this article, you will be able to explain how divisional performance is measured using key financial indicators, distinguish between Return on Investment (ROI) and Residual Income (RI), analyse the benefits and drawbacks of each measure, and identify the behavioural effects these measures can create for managers. You will also understand how divisional performance evaluation links to motivation, goal congruence, and decision quality in a responsibility accounting environment.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how organisations measure divisional performance and the implications for managerial behaviour. For revision, focus on:

• The identification and purpose of investment centres
• Calculation and interpretation of Return on Investment (ROI)
• Calculation and interpretation of Residual Income (RI)
• Advantages and limitations of ROI and RI as performance measures
• The behavioural consequences of performance measurement systems
• The link between divisional targets, controllable profit, and motivation
• Goal congruence in divisionalised organisations

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main difference between ROI and RI as measures of divisional performance?
2. Give two limitations of using ROI to assess divisional managers.
3. True or false? A divisional manager should always accept additional investment opportunities if they increase the division's ROI.
4. Briefly describe how setting divisional targets can impact managerial motivation.
5. Explain the term "goal congruence" in divisional performance measurement.

Introduction

Organisations often divide their operations into separate units—known as divisions or investment centres—to improve performance accountability and decision-making. Measuring divisional performance is essential to ensure each manager is contributing to the company’s objectives. Two primary measures used are Return on Investment (ROI) and Residual Income (RI). Choosing between these measures—and understanding their advantages, limitations, and behavioural effects—is critical for achieving both strong divisional results and overall organisational success.

Key Term: investment centre
A responsibility centre where the manager is accountable for revenues, costs, and the capital invested, and is evaluated on the return generated from that investment.

DIVISIONAL PERFORMANCE MEASUREMENT

Responsibility Centres

A large organisation is often separated into different parts, each with a manager responsible for specific results. These are classified as cost, revenue, profit, or investment centres.

Cost centres focus on costs, revenue centres on sales, profit centres on both revenues and costs, and investment centres add accountability for the capital employed.

Key Term: responsibility accounting
An accounting system that collects and reports revenues, costs, and capital employed attributed to individual managers' areas of control.

Why Measure Performance?

Measuring divisional performance allows:

• Managers to be held accountable for the resources they control
• Comparison of results between divisions
• Evaluation of investments in assets
• Links between performance and incentives

The core challenge is designing measures that encourage managers to act in the best interests of the organisation as a whole.

RETURN ON INVESTMENT (ROI)

ROI is the most commonly used quantitative measure for comparing divisional returns. It expresses the controllable profit as a percentage of the capital employed in the division.

ROI (%) = (Controllable profit / Controllable capital employed) × 100

• Controllable profit: The profit over which the divisional manager has decision-making power (typically before tax and after depreciation).
• Controllable capital employed: Divisional assets managed directly by the manager.

Key Term: Return on Investment (ROI)
A financial metric that measures the profitability of an investment centre by expressing controllable profit as a percentage of the division’s capital employed.

Worked Example 1.1

A division earns $200,000 in controllable profit on $1,000,000 of controllable assets. Calculate ROI.

Answer:
ROI = ($200,000 / $1,000,000) × 100 = 20%

Advantages of ROI

• Enables performance comparison between divisions of different sizes
• Combines income and asset utilisation into one measure
• Expressed as a percentage, making results easy to compare with company targets

Limitations of ROI

• May motivate managers to reject beneficial projects if they reduce the average ROI (even if they increase overall profit)
• Encourages short-term focus on raising the measure, sometimes at the expense of long-term value
• Different accounting policies for depreciation or asset valuation can distort comparisons
• May lead to underinvestment in new assets to protect short-term ROI

Worked Example 1.2

A division currently has ROI of 20%. Management is considering a new project requiring $250,000 of new assets and generating $45,000 profit per year (18% ROI). Should the manager accept, based solely on ROI?

Answer:
No. Accepting the project would lower the division’s total ROI below 20%. The manager may reject a potentially profitable investment to avoid reducing their reported performance.

Exam Warning

Divisional managers may focus on their own performance targets if measured purely by ROI, leading to decisions that reduce overall company profits but protect divisional ROI.

RESIDUAL INCOME (RI)

Residual Income (RI) provides an alternative that addresses some ROI issues. RI calculates the profit achieved above a notional “cost of capital” for the assets employed.

RI = Controllable profit – (Notional interest rate × Controllable capital employed)

• The notional interest rate reflects the minimum acceptable return for the company’s capital.

Key Term: Residual Income (RI)
The profit earned by an investment centre after deducting a charge for the notional cost of capital employed by the division.

Worked Example 1.3

A division earns $90,000 profit on $500,000 assets; notional cost of capital is 12%. Calculate RI.

Answer:
RI = $90,000 – (12% × $500,000)
RI = $90,000 – $60,000 = $30,000

Advantages of RI

• Encourages managers to accept any project with a return above the cost of capital, even if below current ROI
• Encourages decisions benefitting the company as a whole
• Uses absolute $ values—easier to link with increases in shareholder wealth

Limitations of RI

• Difficult to compare across divisions of different size (not a percentage)
• Requires clear agreement on the notional cost of capital and asset valuations
• Still sensitive to arbitrary accounting allocations

BEHAVIOURAL EFFECTS OF PERFORMANCE MEASURES

Measurement systems do not simply report performance—they influence behaviour.

Goal Congruence

Goal congruence occurs when managers acting in their own best interests also benefit the company overall. The right performance measures encourage alignment between divisional and company objectives.

Key Term: goal congruence
A situation where managers’ actions, motivated by the performance measures used, assist in achieving the organisation’s overall objectives.

Motivation and Behavioural Issues

• ROI may discourage managers from investing in new assets or accepting lower-return positive-NPV projects
• RI supports acceptance of all projects above the company’s hurdle rate, encouraging better decisions
• Tying bonuses to divisional profit, ROI, or RI can encourage either short-termism or true value creation
• Too much focus on one measure can cause manipulation or risk-averse behaviour

Worked Example 1.4

If a manager’s bonus is based only on ROI, what bias might occur in investment decisions?

Answer:
The manager may turn down investments with returns exceeding the company’s cost of capital if they reduce the division’s average ROI, resulting in lost profit opportunities for the company.

Controllable vs Non-Controllable Factors

Performance should be assessed based on matters the manager can influence—controllable profit and assets. Assigning responsibility for uncontrollable costs demotivates managers and creates fairness issues.

Revision Tip

For exam questions, always consider whether a proposed performance measure encourages decisions aligned with overall company goals.

COMPARING ROI AND RI

Summary

ROI and RI are key tools for evaluating divisional performance in investment centres. ROI offers comparability but can lead to dysfunctional behaviour and underinvestment. RI provides better alignment with company objectives but is harder to compare across divisions. Choosing and combining performance measures, while considering their motivational impact, is essential for effective divisional management.

Key Point Checklist

This article has covered the following key knowledge points:

• The purpose and calculation of ROI and RI in investment centres
• Advantages and limitations of ROI and RI as performance measures
• The behavioural impact of each measure on managerial decisions
• The concept of goal congruence in divisional management
• The need to evaluate controllable profit/assets
• The importance of linking performance measurement to company objectives

Key Terms and Concepts

• investment centre
• responsibility accounting
• Return on Investment (ROI)
• Residual Income (RI)
• goal congruence