ROI RI and EVA performance evaluation - Ratio definitions st...

Learning Outcomes

By the end of this article, you will be able to define and calculate Return on Investment (ROI), Residual Income (RI), and Economic Value Added (EVA), explain how each is used in divisional performance evaluation, and critically compare their strengths and weaknesses. You will also identify the implications of using different performance measures and understand common examiner expectations in ACCA APM.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand and evaluate financial performance measures used for divisional and organisational appraisal. Focus your revision on:

• The purpose and calculation of ROI, RI, and EVA in a divisionalised structure
• The advantages and limitations of each measure in relation to shareholder value and managerial motivation
• The impact of performance metrics on decision-making and potential for dysfunctional behaviour
• Comparison and interpretation of performance measures in practical scenarios

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. Which measure incentivises a divisional manager to accept any investment exceeding the cost of capital?
   1. ROI
   2. RI
   3. Gross profit margin
   4. Asset turnover

2. True or False? EVA makes adjustments to accounting profit to better reflect long-term shareholder value.

3. Why might evaluating performance on ROI alone lead to suboptimal investment decisions?

4. Calculate the RI for a division with an operating profit of $80,000, capital employed of $400,000, and a cost of capital of 12%.

Introduction

Performance evaluation in divisionalised companies relies on robust financial metrics. Three measures are commonly encountered in ACCA APM: ROI, RI, and EVA. Although each is designed to capture profitability and efficiency, they differ in approach, incentive effect, and alignment with shareholder interests. This article explains how each is calculated, discusses practical strengths and weaknesses, and provides guidance for interpreting their outcomes in the context of divisional management and exam requirements.

Key Term: Return on Investment (ROI)
ROI is a relative measure of profitability, calculated as operating profit divided by capital employed, usually expressed as a percentage. It shows how efficiently a division or company generates profit from the resources invested.

Key Term: Residual Income (RI)
RI is the absolute profit remaining after deducting a notional charge for the cost of capital on assets employed from the operating profit. It indicates the value generated over and above the minimum return expected by providers of finance.

Key Term: Economic Value Added (EVA)
EVA is a performance measure derived from RI, making additional adjustments to accounting profit and capital employed to better reflect the true economic value created for shareholders.

ROI, RI, and EVA: Definitions and Calculations

ROI (Return on Investment)

ROI is calculated as:

$\text{ROI} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100$

• Operating Profit: Usually profit before interest and tax, after controllable costs.
• Capital Employed: Typically total assets less current liabilities, or the funds invested in a division.

ROI Strengths

• Easy to compute and widely recognised
• Allows direct comparison between divisions or companies of different sizes
• Encourages efficient use of assets

ROI Weaknesses

• Risk of dysfunctional behaviour: managers may reject investments that are profitable to the group but lower their division’s ROI
• Can be manipulated by delaying investments or disposing of assets
• Not directly linked to absolute shareholder wealth
• Affected by different accounting policies and age of assets

Worked Example 1.1

A division has capital employed of $500,000 and annual operating profit of $100,000. Calculate its ROI.

Answer:
ROI = ($100,000 / $500,000) × 100 = 20%

Exam Warning

Divisions evaluated solely on ROI may reject projects yielding a return above the company’s cost of capital if those projects reduce the division’s average ROI. In the exam, always state whether an investment benefits the group even if ROI appears to fall.

RI (Residual Income)

RI is calculated as:

$\text{RI} = \text{Operating Profit} - (\text{Capital Employed} \times \text{Cost of Capital})$

• Cost of Capital: The minimum required rate of return expected by investors.

RI Strengths

• Encourages managers to undertake all investments that earn above the cost of capital
• Absolute measure; positive RI shows value is created for shareholders
• Reduces suboptimal behaviour seen with ROI (rejecting good projects)

RI Weaknesses

• Not a relative measure; absolute numbers make comparisons across divisions difficult
• Requires agreement on appropriate cost of capital
• Can still be influenced by accounting choices

Worked Example 1.2

A division earns $40,000 profit on $200,000 employed. The cost of capital is 12%. Calculate RI.

Answer:
RI = $40,000 – ($200,000 × 12%) = $40,000 – $24,000 = $16,000

EVA (Economic Value Added)

EVA refines RI by adjusting accounting profit and capital to more closely approximate economic profit:

$\text{EVA} = \text{Net Operating Profit After Tax (NOPAT)} - (\text{Adjusted Capital Employed} \times \text{WACC})$

Difference from RI:

• Adjusts profit for factors such as R&D, provisions, tax, and non-cash expenses
• Uses weighted average cost of capital (WACC)

EVA Strengths

• Strong alignment with shareholder value creation
• Makes key adjustments to address limitations of accounting profit
• Useful for assessing divisional and group performance over time

EVA Weaknesses

• Requires many (sometimes subjective) adjustments to profit and capital
• More complex and time-consuming to calculate
• May be harder for divisional managers to understand and act upon

Worked Example 1.3

Division X has NOPAT of $120,000. Adjusted capital employed is $800,000 and WACC is 10%. Calculate EVA.

Answer:
EVA = $120,000 – ($800,000 × 10%) = $120,000 – $80,000 = $40,000

Comparison: ROI, RI, and EVA

Common Pitfalls and Managerial Behaviour

• ROI focus can deter managers from investing in worthwhile projects: If a project’s return is above the company’s cost of capital but below the current divisional ROI, managers may reject it.
• Using absolute measures like RI and EVA facilitates decision-making: They indicate whether an investment adds value, regardless of its impact on ratios.
• Accounting policy differences can affect all measures: Especially EVA, which tries to correct for this with adjustments.

Revision Tip

When comparing different divisions, rely on ROI for a quick comparison but use RI or EVA for investment decisions and alignment with group objectives.

Summary

ROI, RI, and EVA are key divisional performance measures for the ACCA APM exam. ROI is simple and widely used but can lead to suboptimal decisions. RI overcomes this limitation by rewarding any investment above the cost of capital, though it is less comparable across divisions. EVA refines RI to align more closely with shareholder value, but requires more information and adjustments.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and calculate ROI, RI, and EVA for divisional performance
• Explain the advantages and disadvantages of each measure
• Identify the behavioural effects and potential for dysfunctional decisions
• Apply these measures to ACCA-style scenarios and questions
• Recognise how EVA aligns with long-term shareholder value

Key Terms and Concepts

• Return on Investment (ROI)
• Residual Income (RI)
• Economic Value Added (EVA)