ACCA PM Syllabus E. Performance Measurement And Control - ROI and RI - Notes ^{2 / 2}

Measures of divisional performance

Decentralisation is the delegation of decision-making to lower levels of management.

One disadvantage of decentralisation is that managers may make decisions that are not in the best interests of the overall company (dysfunctional decisions). 

Hence, senior managers need to introduce systems of performance measurement to ensure that decisions made by junior managers are in the best interests of the company as a whole.

In an investment centre, managers have the responsibilities of a profit centre plus responsibility for capital investment. Two measures of divisional performance are commonly used:

1. Return on investment (ROI)
                                       
   controllable (traceable) profit % 
   --------------------------------------                                           
   controllable (traceable) investment

2. Residual income

   controllable (traceable) profit - an imputed interest charge on controllable (traceable) investment.

Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum.

Would you rather borrow $100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%?

Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of $15 per annum after borrowing costs.

The bigger investment would give a net return of $50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth.

Residual income also ties in with net present value, theoretically the best way to make investment decisions. In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth.

Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance.

Problems common to both ROI and Residual Income

The following problems are common to both measures

1. Identifying controllable (traceable) profits and investment can be difficult.

2. If used in a short-term way they can both over-emphasise short-term performance at the expense of long-term performance. Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to rejection of projects by managers.

3. If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery.

4. Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern businesses, multi-faceted measures of performance are necessary.

5. Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.