## **Learning Outcomes**

After studying this article, you will be able to calculate and interpret Return on Investment (ROI) and Residual Income (RI), discuss their advantages and shortcomings, and describe the basic principles of Economic Value Added (EVA). You will understand how these measures are used to assess divisional performance, recognise their impact on management behaviour, and identify common exam pitfalls for the ACCA Performance Management (PM) paper.

## **ACCA Performance Management (PM) Syllabus**

For ACCA Performance Management (PM), you are required to understand the use of financial metrics to monitor divisional performance and managerial effectiveness. Focus your revision on the following syllabus points, as each is likely to be examined:

- The calculation and interpretation of ROI and RI for investment centres and divisions
- The strengths, limitations, and behavioural effects of ROI and RI as performance measures
- Comparison of divisional performance, including problems in inter-divisional benchmarking
- The purpose and calculation fundamentals of Economic Value Added (EVA) as an alternative measure
- The influence of performance measures on managerial decision making and goal congruence

## **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. A division generated a profit of \$36,000 with net assets of \$150,000. What is its ROI?
2. Briefly explain how Residual Income (RI) differs from ROI in divisional performance appraisal.
3. A company uses a hurdle rate of 12%. A division with \$500,000 in assets achieved \$65,000 profit. Should the manager invest in a new project with 10% ROI? Why or why not according to RI?
4. State one strength and one potential weakness of using ROI for appraising divisional managers.
5. What does a positive Economic Value Added (EVA) indicate about a business’s performance?

## **Introduction**

Performance management in decentralised organisations often requires assessing the profitability and value delivered by separate divisions or investment centres. Financial performance measures such as Return on Investment (ROI), Residual Income (RI), and Economic Value Added (EVA) are used to compare divisions, set targets for managers, and motivate behaviours that align with the company's overall objectives.

Selecting the right metric is essential for both fair appraisal and strategic decision making. The wrong choice can encourage managers to make decisions that are suboptimal for the business.

> **Key Term: investment centre**
> A business unit for which both revenues and costs, as well as assets employed, are measured and managers are accountable for profits and investments.
>
> **Key Term: ROI (Return on Investment)**
> A relative measure of performance expressed as the ratio of controllable profit to the capital (assets) employed in a division or business unit, usually as a percentage.
>
> **Key Term: RI (Residual Income)**
> A measure of performance calculated as net controllable profit less a notional interest charge on the capital invested, using a specified cost of capital or target return.
>
> **Key Term: Economic Value Added (EVA)**
> A performance measure that adjusts accounting profit by deducting a charge for all capital employed, based on economic principles rather than standard accounting rules.

## **Financial Performance Measures for Divisions**

### ROI: Calculation and Interpretation

Return on Investment (ROI) is the classic measure used in investment centres. It is calculated as:

ROI (%) = (Controllable Profit / Capital Employed) x 100

- **Controllable profit** is usually operating profit before interest and tax, after depreciation, and adjusted to exclude items not managed by divisional management.
- **Capital employed** typically means net assets—total assets less current liabilities. For appraisal, use average capital during the period if available.

ROI enables comparison between divisions or investments of different sizes.

### **Worked Example 1.1**

A division made \$40,000 profit. Net assets at period end are \$200,000. Calculate ROI.

> **Answer:**
>
> ROI = (40,000 / 200,000) x 100 = 20%

#### Common issues in ROI comparisons

- Asset values might be at cost, net book value, or replacement cost.
- Some assets (e.g., centralised receivables balances) may not be under the division manager’s control. Exclude uncontrollable assets for fair comparison.
- For new investments, using end-period capital employed can understate ROI.

### Advantages of ROI

- Standardised % allows comparison across divisions or years.
- Links profit to resources consumed.
- Commonly used in business, so managers may already be familiar.

### Disadvantages of ROI

- **Encourages dysfunctional behaviour:** Managers might reject projects with ROI below the division’s current rate, even if such projects exceed the firm's target return.
- **Short-term focus:** ROI can be increased by deferring expenditure or selling off assets.
- **Asset age distortion:** Divisions with older assets and low book values can have artificially high ROI.
- **Accounting manipulation:** Managers may be incentivised to adjust capital or delay costs to boost ROI.

### **Worked Example 1.2**

Division East currently achieves 24% ROI. It is offered a project requiring \$250,000 investment with a forecast profit of \$50,000. Should the manager accept if the company’s target ROI is 15%?

> **Answer:**
>
> Project ROI = (\$50,000 / \$250,000) x 100 = 20%
> Division manager may reject the project because 20% < current 24% division ROI, even though 20% > company target. This is known as “dysfunctional decision making”.

### **Exam Warning**

> Be careful not to assess managers using ROI alone. Highlight in answers that ROI may demotivate managers or lead to suboptimal decisions for the company.

## **Residual Income (RI): A Solution to ROI’s Weaknesses**

Residual Income (RI) seeks to overcome some limitations of ROI by expressing profit as an absolute surplus over the minimum required return.

RI = Controllable Profit – (Capital Employed x Cost of Capital)

- **Cost of capital** or hurdle rate represents the company’s minimum acceptable return.

### Advantages of RI

- Encourages acceptance of any project that earns more than the minimum required return, regardless of the current division ROI.
- Can use different hurdle rates for divisions with varying risk.

### Disadvantages of RI

- Not a percentage—harder to compare different sized divisions.
- Still relies on profit numbers subject to accounting manipulation.
- Like ROI, can be affected by accounting policies and depreciation methods.

### **Worked Example 1.3**

A division made \$90,000 profit with \$600,000 employed. Company hurdle rate is 10%.

> **Answer:**
>
> RI = \$90,000 – (10% x \$600,000) = \$90,000 – \$60,000 = \$30,000

Positive RI means the division exceeded the company’s target return. Any investment that increases RI is desirable for the company.

#### Comparison: ROI vs. RI in investment decisions

Suppose another division has \$1,000,000 assets, \$200,000 profit, and is offered a \$200,000 project earning \$30,000 profit (i.e., 15% ROI) and the company hurdle rate is 12%:

- Project ROI: \$30,000 / \$200,000 = 15% (above hurdle rate)
- Without the project, division ROI = 20%. With the project, new total profit = \$230,000, new assets = \$1,200,000, so ROI = 19.2%. ROI falls.
- Division manager measured on ROI may reject the project.
- RI before project: \$200,000 – (12% x \$1,000,000) = \$80,000
- RI after project: \$230,000 – (12% x \$1,200,000) = \$86,000 (increase: \$6,000)
- Under RI, project is accepted, which is aligned with company interests.

### **Revision Tip**

> When asked to compare ROI and RI, always discuss their behavioural effects on management as well as their calculation and comparison limitations.

## **Economic Value Added (EVA): Modern Value-Based Performance**

Economic Value Added (EVA) is an alternative performance measure that seeks to provide a more economic view of value creation. It adjusts both profit and capital employed for accounting distortions and non-cash items.

Key features:

- Profit is adjusted for non-cash and accruals (e.g., amortisation, non-recurring items)
- Capital employed may be based on replacement or current values rather than book value
- The charge for capital is based on the company’s real cost of capital (after tax, including all sources of funding)

EVA = Net Operating Profit After Taxes (NOPAT, adjusted) – (Capital Employed x Weighted Average Cost of Capital)

A positive EVA indicates the division or company is creating value above the full economic cost of capital.

> **Key Term: Net Operating Profit After Taxes (NOPAT)**
> Operating profit of the business after tax, adjusted to reflect true core performance.

### Strengths of EVA

- Attempts to remove many distortions arising from standard accounting policies.
- Focuses attention on true economic profit and capital charges, not just accounting profit.

### Limitations of EVA

- Calculation can be complex and require significant adjustments—lack of standardisation between firms.
- Debatable for comparing divisions unless all data is prepared on a consistent basis.

### **Worked Example 1.4**

A business division has adjusted NOPAT of \$240,000 and adjusted capital employed of \$1,500,000. The company’s weighted average cost of capital is 11%.

> **Answer:**
>
> EVA = \$240,000 – (\$1,500,000 x 11%) = \$240,000 – \$165,000 = \$75,000
> The division has created \$75,000 of real economic value during the period.

## **Summary**

ROI, RI, and EVA are financial performance measures used to appraise divisions and investment centres. ROI is easy to calculate and compare but can create perverse incentives and lead to dysfunctional decisions. RI addresses some of these weaknesses by focusing on additional profit over the cost of capital, but absolute amounts can be hard to compare across divisions of differing size. EVA aims for a more accurate measure of value creation by making economic adjustments, though its calculations may be complex.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Calculate and interpret ROI and RI for divisions or business units
- Explain why ROI can distort divisional comparisons or result in suboptimal decisions
- Discuss the advantages and disadvantages of both ROI and RI
- Explain the behavioural effects of performance measures on managers’ actions
- Outline the principles of EVA and the practical challenges in applying it
- Recognise situations where each measure is appropriate or may lead to common exam errors

## **Key Terms and Concepts**

- investment centre
- ROI (Return on Investment)
- RI (Residual Income)
- Economic Value Added (EVA)
- Net Operating Profit After Taxes (NOPAT)


Financial performance measures - ROI, RI, and EVA