Learning Outcomes
After reading this article, you will be able to explain the aims of divisional performance measurement, calculate and interpret return on investment (ROI) and residual income (RI), and evaluate their suitability for assessing investment centre performance. You will recognise the strengths and drawbacks of each approach, understand their effects on decision-making and goal alignment, and identify typical calculation issues for the ACCA exam.
ACCA Management Accounting (MA) Syllabus
For ACCA Management Accounting (MA), you are required to understand how divisional performance is measured using financial indicators. This article covers key syllabus areas, including:
- The purpose of divisional performance measures in investment centres
- Calculation and interpretation of return on investment (ROI) and residual income (RI)
- Advantages and limitations of ROI and RI for managerial appraisal and decision-making
- Issues affecting practical use of these measures, such as goal congruence and asset valuation
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.
- What is the main difference between ROI and RI when assessing a division's performance?
- A division achieves a profit of $60,000 on capital employed of $500,000. What is its ROI?
- If a company's notional cost of capital is 8%, calculate the RI for a division with $700,000 capital employed and a profit of $65,000.
- Which of ROI or RI is more likely to encourage managers to accept all profitable investments? Why?
Introduction
Measuring performance in divisionalised organisations requires reliable financial indicators. Investment centres are divisions where managers are judged on both earnings and the assets controlled. The two most commonly used financial measures are return on investment (ROI) and residual income (RI). Understanding how to calculate, interpret, and apply these measures is essential for effective performance evaluation and supporting the goals of the wider organisation.
Key Term: Investment Centre
A part of an organisation whose manager is responsible for both generating profits and efficiently managing the assets invested.
PERFORMANCE MEASUREMENT IN INVESTMENT CENTRES
Divisional performance measurement allows head office to appraise the effectiveness of each division, compare results fairly, and motivate managers towards organisational objectives. The measures used must capture both profitability and how well assets are used.
Financial Performance Indicators
The two primary financial indicators for investment centres are ROI and RI.
Key Term: Return on Investment (ROI)
A percentage measure showing profit earned per unit of capital invested, calculated as profit divided by capital employed, expressed as a percentage.Key Term: Residual Income (RI)
The amount of profit remaining after deducting a notional cost of capital from divisional profits, representing income earned above a minimum required return.
CALCULATING ROI AND RI
ROI – Return on Investment
ROI evaluates how efficiently a division uses its assets to generate profit. It is the most commonly used measure for comparing divisions of different sizes.
ROI = (Divisional profit / Capital employed) × 100
- Divisional profit: Usually operating profit before interest and tax, after charging depreciation and only including income and costs controllable by the division.
- Capital employed: The assets controlled by the division, typically measured as total assets less current liabilities.
Key Term: Capital Employed
The net assets under divisional control, typically calculated as total assets minus current liabilities, or as non-current assets plus net working capital.
RI – Residual Income
RI determines the absolute profit left to the division after charging a notional cost of capital on funds invested. This encourages the acceptance of any project generating a return above the hurdle rate.
RI = Divisional profit – (Cost of capital × Capital employed)
- The notional cost of capital is set by the company as the required target return for investments.
Worked Example 1.1
A division accrues a profit of $90,000 and controls assets worth $600,000. The company sets a notional cost of capital at 10%.
- Calculate ROI for the division.
- Calculate RI for the division.
Answer:
ROI = ($90,000 / $600,000) × 100 = 15% RI = $90,000 – (10% × $600,000) = $90,000 – $60,000 = $30,000
INTERPRETING ROI AND RI
ROI Interpretation
A higher ROI suggests effective use of assets. Comparisons between divisions and benchmarking against company targets are straightforward.
However, ROI as a relative measure creates a risk: A manager may reject projects whose ROI is below the division’s current ROI, even if the new investment meets the company’s minimum required return. This can discourage managers from accepting investments that are profitable for the whole business but lower the division’s average ROI.
Key Term: Goal Congruence
A situation where decisions made by individual managers are aligned with, and support, the objectives of the wider organisation.Key Term: Sub-Optimal Decision
A decision which is best for an individual division or manager, but not for the organisation overall.
RI Interpretation
RI encourages divisions to accept any additional investment that increases absolute profit above the minimum required return. Managers are rewarded for increasing total profits, not just maintaining a high average rate of return. This approach supports better goal congruence.
Worked Example 1.2
A division has $1,200,000 of capital employed and earns a profit of $180,000. The company’s cost of capital is 12%. A proposed investment of $200,000 is forecast to earn $18,000 additional annual profit. Should the manager accept the project?
- Current ROI: $180,000 / $1,200,000 × 100 = 15%
- Project ROI: $18,000 / $200,000 × 100 = 9%
- Combined ROI if accepted: ($180,000+$18,000)/($1,200,000+$200,000) × 100 ≈ 13.25% (lower than before)
- Current RI: $180,000 – ($1,200,000 × 12%) = $180,000 – $144,000 = $36,000
- Combined RI if accepted: $198,000 – ($1,400,000 × 12%) = $198,000 – $168,000 = $30,000
Answer:
ROI falls if the project is accepted, so a manager judged only on ROI might reject the investment. However, since total RI is still positive, and the project’s profit matches the hurdle rate exactly (9% is below both the division’s current ROI and the cost of capital), the manager would be indifferent by RI but should prefer projects that add more than zero RI. Projects with positive RI improve shareholder wealth.
Exam Warning
If a divisional manager is evaluated only on ROI, the manager may reject profitable projects that decrease the division’s average ROI but raise overall group profits. Always check whether the measure used creates potential conflicts between divisional and corporate objectives.
ADVANTAGES AND LIMITATIONS OF ROI AND RI
ROI
Advantages of ROI
- Easy to calculate and widely used
- Enables quick comparisons between divisions of different sizes
- Focuses attention on asset utilisation as well as profit
Disadvantages of ROI
- May lead to managers rejecting good investments if they reduce average ROI
- Susceptible to manipulation by delaying capital expenditure or changing accounting policies
- Does not measure the absolute value added to the business
RI
Advantages of RI
- Encourages acceptance of all profitable projects above the required return
- Better supports goal congruence between managers and organisation
- Absolute measure of added profit, not diluted by size
Disadvantages of RI
- Difficult to compare divisions of different sizes as larger units naturally have higher RI
- Depends on appropriate selection of cost of capital
- Less common and less intuitively understood than ROI
Worked Example 1.3
Two divisions report the following results:
- Division L: Profit = $55,000; Capital employed = $450,000
- Division M: Profit = $80,000; Capital employed = $1,000,000
- The company’s notional cost of capital is 10%.
Calculate ROI and RI for each division.
Answer:
ROI (L) = $55,000 / $450,000 × 100 ≈ 12.2% ROI (M) = $80,000 / $1,000,000 × 100 = 8% RI (L) = $55,000 – ($450,000 × 10%) = $55,000 – $45,000 = $10,000 RI (M) = $80,000 – ($1,000,000 × 10%) = $80,000 – $100,000 = –$20,000
Division L has a higher ROI and positive RI; Division M’s ROI falls short of the required rate and RI is negative, meaning it does not meet the group’s return target.
PRACTICAL CONSIDERATIONS IN USING ROI AND RI
Non-Financial Measures
Using only financial metrics such as ROI and RI can miss other important aspects of performance. Consider non-financial indicators, such as quality, customer retention, employee development, and innovation, for a balanced view.
Asset Valuation
Choice of asset valuation method (cost, net book value, replacement cost) affects ROI or RI, and makes inter-divisional comparisons harder.
Short-Term Focus
Managers under pressure to maintain ROI or RI may avoid necessary expenditure, defer maintenance, or take decisions that improve short-term results at the expense of strategic performance.
Controllable vs. Non-Controllable Items
Performance measures should centre on factors the manager can influence. Allocating uncontrollable central costs or external market effects can distort divisional appraisals.
Revision Tip
In exam questions, state both the calculation and the wider implications—always consider if the recommended measure drives managers to act in line with the organisation’s interests.
Summary
Return on investment (ROI) and residual income (RI) are key measures for judging the performance of investment centres. ROI gives a simple percentage, clear for comparisons, but can create conflicts between divisional and group objectives. RI is an absolute measure, encourages acceptance of valuable projects, and supports better goal alignment, though it is less suited for comparing divisions of different sizes. Both measures should be supplemented with qualitative and non-financial information for a full assessment of divisional effectiveness.
Key Point Checklist
This article has covered the following key knowledge points:
- The need for divisional performance measurement in investment centres
- How to calculate and interpret ROI and RI
- The strengths and weaknesses of ROI and RI as performance measures
- The impact of ROI and RI on managerial behaviour and organisational objectives
- Practical issues in using financial metrics and the importance of non-financial measures
Key Terms and Concepts
- Investment Centre
- Return on Investment (ROI)
- Residual Income (RI)
- Capital Employed
- Goal Congruence
- Sub-Optimal Decision