CAT / FIA FMA Syllabus F. Performance Measurement - Profitability in Performance Measure - Notes ^{15 / 15}

Decentralisation is taking decision-making away from head office - particularly useful in large and complex organisations

However, managers may use their decision-making freedom for their best interests and not necessarily that of the organisation (so called dysfunctional decisions).

So performance measurement systems try to ensure that all are in the best interests of the organisation as a whole.

Return On Investment and Residual Income

For an investment centre:

1. Return on Investment (ROI)

   Controllable Profit 
   ---------------------------
   Controllable Investment

2. Residual income

   Controllable Profit - Interest charge on controllable investment.

Advantages of ROI

1. Simple and low cost

2. Widely used measure, so comparisons easy

3. Percentage result, so it can be used to compare units which differ in size

Disadvantages of ROI

1. Based on accounting information (profit figures and asset figures), which suffers from different accounting policies, eg. depreciation and estimates

2. Open to manipulation by managers, especially if bonuses are at stake

3. May be distorted by inflation as historical cost accounts do not reflect the current value of the assets

4. ROI may discourage investment and re-equipment in more technologically up to date assets. 

   Old assets, almost fully depreciated, will give a low asset base in the ROI calculation, which will result in an increased figure for ROI and give the impression of an improved level of performance

5. ROI may lead managers to take decisions which are to their advantage but which do not benefit the organization as a whole -  it leads to dysfunctional behaviour

Advantages of Residual Income

• investment centre managers see the imputed interest charge – this makes them aware of the financial implications of their investment decisions

• RI should avoid dysfunctional decision making – it ensures decisions are taken which benefit both the investment centre and the company or group as whole – goal congruency

Disadvantages of Residual Income

• RI is still an accounting-based measure

• RI gives an absolute measure – very difficult to compare the performance of investment centres of different sizes – the bigger investment centre will tend to produce the bigger figure for RI

• An appropriate target, which is seen to be fair to all divisions, may be difficult to determine

• A major problem inherent in the RI calculation is the determination of an appropriate imputed interest rate