Learning Outcomes
After reading this article, you will be able to distinguish between Return on Investment (ROI), Residual Income (RI), and Economic Value Added (EVA) as divisional performance measures. You will understand issues of comparability across divisions, the principle of controllability, and how inflation can distort results and performance evaluation. You will also identify practical solutions for these challenges.
ACCA Advanced Performance Management (APM) Syllabus
For ACCA Advanced Performance Management (APM), you are required to understand not just the calculation of ROI, RI, and EVA, but their application, limitations, and the contexts in which they may produce misleading results. In particular, your revision should focus on:
- Evaluating ROI, RI, and EVA for measuring divisional and managerial performance
- Explaining the effects of inflation on financial performance measures
- Discussing issues with comparing results across divisions and organisations
- Applying the principle of controllability in performance evaluation
- Recommending measures to improve performance reporting accuracy and fairness
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.
- If Division A and Division B use different depreciation methods, what performance measure problem might arise when comparing their ROI results?
- Which divisional performance measure most directly incorporates the organisation’s cost of capital: ROI, RI, or EVA?
- True or false? Inflation can make it appear that a division’s ROI has improved even when real performance has not.
- Briefly explain the controllability principle in performance evaluation.
- List two actions that can improve comparability between divisions in performance reporting.
Introduction
Measuring divisional performance fairly and accurately is essential for strategic control and managerial accountability. Financial measures such as ROI, RI, and EVA provide numerical benchmarks, but their value depends on consistent, transparent, and relevant application. Problems arise when divisions are compared without accounting for differences in accounting policy, asset age, inflation, or degree of control over performance drivers. This article examines how to use ROI, RI, and EVA, the challenges in their practical application, and methods to strengthen their reliability.
Key Term: Return on Investment (ROI)
ROI expresses divisional profit as a percentage of capital employed, indicating how efficiently assets are used to generate operating profit.Key Term: Residual Income (RI)
RI is the operating profit of a division after deducting a notional interest charge reflecting the company’s required rate of return on capital employed.Key Term: Economic Value Added (EVA)
EVA adjusts accounting profit and capital employed to approximate true economic profit, calculating the surplus earned above the weighted average cost of capital (WACC).Key Term: Controllability Principle
Managers should only be held responsible for the elements of performance that they can influence through their own decisions.
Comparability Issues in Division Performance Measurement
Performance measures are only meaningful if valid comparisons can be made. Comparability challenges arise due to:
Accounting Policy Differences
Divisions may use varying methods for depreciation, inventory valuation, or asset revaluation. These differences directly affect reported profits and asset values, distorting ROI, RI, and EVA.
- Example: Straight-line vs reducing balance depreciation alters profit and asset base, skewing ROI.
Asset Age and Capital Intensity
Older divisions tend to have lower net book value of assets, artificially inflating ROI and RI. New divisions may appear less efficient due to higher asset values, even if operational performance is identical.
Size of Division
Measures such as RI and EVA are absolute and thus influenced by the scale of operations. Comparing a large and small division using absolute RI or EVA may be misleading.
Inflation and Outdated Asset Valuation
When asset values are not updated for inflation, older assets appear cheaper, boosting ROI and RI. Profits measured at current prices on older, lower-value assets exaggerate performance. Conversely, new capital-intensive divisions look less attractive.
Accounting Adjustments and EVA
EVA further complicates comparability because it requires numerous adjustments to profit and capital employed. Consistency in applying these adjustments across divisions is essential; otherwise, EVA figures are not comparable.
Worked Example 1.1
A company has two divisions. Division Alpha’s plant assets are 10 years old, and Division Beta’s are 1 year old. Both have identical operating profits this year, but Alpha’s ROI is 24% while Beta’s is 11%. Explain the reason.
Answer:
Alpha’s assets are heavily depreciated, resulting in a low asset base, so ROI appears higher. However, this does not mean Alpha is managed better; it simply reflects asset age effects. Comparing such ROI figures is misleading.
Controllability in Performance Evaluation
Holding managers responsible for items outside their control is demotivating and leads to dysfunctional behaviour. Performance reports should reflect only revenues and costs managers can directly affect.
- Costs incurred centrally, set transfer prices, or externally imposed charges should be excluded from managers’ appraisals.
- Investment or asset allocation decisions made by head office should not impact divisional managers unless they had authority over those decisions.
Worked Example 1.2
A division manager is held accountable for profit after allocating group-wide IT costs. The manager had no control over this expense. How should performance be evaluated?
Answer:
The divisional performance analysis should focus on controllable contribution or controllable profit. Group-wide non-controllable charges should be excluded when appraising the manager.
Exam Warning
In exam scenarios, always check whether performance targets align with factors the manager can influence. A common error is not adjusting for uncontrollable costs, leading to unfair evaluation.
Inflation Effects on ROI, RI, and EVA
Inflation causes profits to be recorded at current price levels while assets (capital employed) are often stated at historical costs. This mismatch can overstate ROI and RI, making divisions look more successful than reality.
- New divisions, with up-to-date asset values, may show apparently poor ROI compared to older ones.
- Inflation leads to under-reported depreciation, overstating profit.
EVA is less susceptible if correct adjustments are made, including revaluing tangible and intangible assets and replacing accounting depreciation with economic depreciation.
Worked Example 1.3
A division invested in a new plant costing $10 million ten years ago. Due to inflation, its replacement cost is now $18 million. ROI is calculated using the old asset value. How does this affect performance measurement?
Answer:
The ROI appears higher, not due to true efficiency, but because the capital base is understated. This overstates divisional performance and creates poor incentives when comparing with divisions who have recently invested.
Revision Tip
If exam data is given in historical cost terms but there is evidence of major inflation or new asset investment, comment on possible distortions and the need for revaluation or adjustment.
Improving Comparability and Accuracy
To minimise unfair comparisons and distorted incentives, organisations can:
- Consistently apply accounting policies for depreciation, asset valuation, and expense allocation across divisions
- Use current cost accounting or regularly revalue key assets, especially in times of significant inflation
- Where possible, allocate only controllable revenues and costs to divisional managers
- Use relative and benchmarked measures, such as ROI compared to an industry average
- Present both ROI and RI/EVA to reveal different performance dimensions
- Supplement financial performance metrics with non-financial indicators
Summary
ROI, RI, and EVA each offer different advantages for divisional evaluation, but all are vulnerable to errors in comparability, controllability, and inflation. Accountants must be alert for differences in accounting policy, asset age, and external influences when analysing divisional results. Adjusting for these factors leads to fairer performance reporting and prevents dysfunctional managerial behaviour.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain ROI, RI, and EVA as divisional performance measures
- Identify comparability issues from accounting policy, asset age, and size
- Describe the principle of controllability and its application
- Analyse how inflation distorts profit-based measures
- Recommend adjustments to financial reporting for fair evaluation
- Recognise exam pitfalls and common errors in interpreting results
Key Terms and Concepts
- Return on Investment (ROI)
- Residual Income (RI)
- Economic Value Added (EVA)
- Controllability Principle