Performance Management · Divisional performance and transfer pricing

ROI and Residual Income: Divisional Performance Measures

Q: What is the difference between ROI and residual income?

ROI is a percentage: profit divided by capital employed. Residual income is a money amount: profit less a capital charge at the cost of capital. RI tends to give better goal congruence, while ROI is easier to compare across divisions of different sizes.

Q: How do I calculate residual income in ACCA PM?

Multiply capital employed by the cost of capital to get the capital charge. Subtract it from divisional profit. Use the profit and capital definitions the question gives.

Q: What is dysfunctional behaviour under ROI?

It is when a manager makes a choice that helps their own ROI but harms the group. For example, rejecting a project that earns more than the cost of capital because it earns less than the division's current ROI.

Q: Can residual income be negative?

Yes. A negative RI means the division earns less than the required return on its capital. It signals that the division is not covering its capital charge.

Updated 11 October 2026 · Fact-checked

ROI is divisional profit as a percentage of capital employed. Residual income (RI) is divisional profit minus a capital charge, which is capital employed multiplied by the cost of capital. ROI can make managers reject projects that are good for the group. RI accepts any project earning above the cost of capital.

Understand Divisional Performance Measures: ROI and Residual Income

A group splits into divisions, and head office needs to judge each division. Profit alone is not enough. A division with ₹50,00,000 profit on a small asset base is doing better than one making the same profit on a huge one. So we compare profit with the capital used.

Return on investment (ROI) does this as a percentage. It is easy to understand and lets you compare divisions of different sizes. Its weakness is behaviour. A manager judged on ROI will refuse a project that earns less than the division's current ROI, even if it earns more than the company's cost of capital. That hurts the group. This is dysfunctional behaviour, or a lack of goal congruence.

Residual income (RI) is an absolute amount. You take divisional profit and deduct a capital charge, which is the cost of capital applied to capital employed. A positive RI means the division earns more than the required return. A manager judged on RI accepts any project with a return above the cost of capital, because it adds to RI. This fits group goals better.

RI has its own limits. It is an absolute figure, so large divisions tend to show larger RI and comparing divisions of different sizes is hard. It also needs a cost of capital, which can be hard to set. Both measures depend on how profit and capital employed are defined, and on asset values such as depreciated book values, which can make old assets look very profitable.

In the exam you will calculate both, compare them, and explain which decision each measure would lead a manager to take.

Key rules to remember

Return on investment: ROI = divisional profit ÷ capital employed × 100%; Use the profit and capital definitions the question gives. Often profit is before interest and tax, and capital employed is total assets less current liabilities.
Capital charge: Capital charge = capital employed × cost of capital; Use the same capital employed figure as in the ROI. Use the rate given, such as the divisional or group cost of capital.
Residual income: RI = divisional profit − capital charge; Profit must be the same measure used for ROI. Positive RI means a return above the required rate.
Project decision rule under ROI: Accept if project ROI > current divisional ROI (manager's likely behaviour); This can reject projects that beat the cost of capital. It is the source of dysfunctional behaviour.
Project decision rule under RI: Accept if project profit − (project investment × cost of capital) > 0; Equivalent to accepting when project return exceeds the cost of capital.

How to solve Divisional Performance Measures: ROI and Residual Income questions

Use this order for any ROI or RI question, whether it asks for calculation, comparison or behaviour.

1Read the definitions given: which profit figure and which capital employed figure to use. Do not substitute your own.
2Calculate current divisional ROI: profit ÷ capital employed × 100%.
3Calculate the capital charge: capital employed × cost of capital. Then RI = profit − capital charge.
4If a new project is involved, work out the project's own profit and investment, and its return.
5Calculate ROI and RI for the division after the project, or the project's own ROI and RI.
6Compare. Ask whether the manager's decision under ROI differs from the decision under RI, and from what is best for the group (return above cost of capital).
7State the conclusion in words: which projects are accepted or rejected, and why this is or is not goal congruent.
8Add one or two limitations if asked, such as size comparison, book values, or the choice of cost of capital.

Quickest way: Project test against the cost of capital

When to use it: When a question asks whether a manager would accept a project under ROI or RI and you are short of time.

Compute project return = project profit ÷ project investment.
Compare with the cost of capital. If higher, the group should accept (RI agrees).
Compare with current divisional ROI. If lower, an ROI-judged manager would reject.
If the project return lies between cost of capital and divisional ROI, you have the classic dysfunctional case.
Write the one-line conclusion with the figures.

Common mistakes in Divisional Performance Measures: ROI and Residual Income

Using different profit or capital figures for ROI and RI.
Students recalculate each measure separately and pick up different numbers.
Fix: Fix the profit and capital employed figures first and use them in both measures.
Deducting the cost of capital percentage from profit instead of the capital charge in money.
Mixing percentages with absolute amounts.
Fix: Always multiply capital employed by the rate first. RI is a money amount.
Saying a higher ROI division is always better.
ROI is a neat percentage so it looks conclusive.
Fix: Compare with the cost of capital and note that a high ROI may reflect old, heavily depreciated assets or a refusal to invest.
Judging a project against the division's ROI when asked what is best for the group.
Confusing the manager's incentive with the group's interest.
Fix: Group interest means project return versus cost of capital. Manager behaviour under ROI means project return versus current ROI.
Comparing RI of divisions of different sizes as if it were a ratio.
RI is an absolute figure and larger divisions naturally show larger amounts.
Fix: Say that RI cannot be fairly compared across different sizes, and use ROI alongside it.
Giving only calculations with no discussion when the question says 'discuss' or 'explain'.
Students focus on the numbers.
Fix: Finish with a short written conclusion on behaviour, goal congruence and limitations.

Worked examples

Example 1

Division X has profit of $360,000 and capital employed of $1,800,000. The group cost of capital is 12%. A new project needs $400,000 of investment and will earn annual profit of $64,000. Calculate ROI and RI before the project, and state whether the divisional manager would accept the project if judged on ROI and if judged on RI.

Show the solution

Current ROI = 360,000 ÷ 1,800,000 = 20%.
Capital charge = 1,800,000 × 12% = 216,000. Current RI = 360,000 − 216,000 = $144,000.
Project return = 64,000 ÷ 400,000 = 16%.
Under ROI: 16% is below the current 20%, so the manager would reject. Check: new ROI = (360,000 + 64,000) ÷ (1,800,000 + 400,000) = 424,000 ÷ 2,200,000 = 19.27%, which is lower than 20%.
Under RI: project charge = 400,000 × 12% = 48,000. Project RI = 64,000 − 48,000 = $16,000, which is positive, so the manager would accept.
The project return of 16% exceeds the 12% cost of capital, so accepting is best for the group.

Answer: Before the project ROI is 20% and RI is $144,000. An ROI-judged manager rejects (project 16% < 20%) but an RI-judged manager accepts (project RI +$16,000). The group should accept, so ROI causes dysfunctional behaviour.

Example 2

Division Y has profit of ₹90,00,000 and capital employed of ₹6,00,00,000. Division Z has profit of ₹30,00,000 and capital employed of ₹1,50,00,000. The cost of capital is 14%. Calculate ROI and RI for each division and comment.

Show the solution

Y ROI = 90,00,000 ÷ 6,00,00,000 = 15%.
Z ROI = 30,00,000 ÷ 1,50,00,000 = 20%.
Y capital charge = 6,00,00,000 × 14% = ₹84,00,000. Y RI = 90,00,000 − 84,00,000 = ₹6,00,000.
Z capital charge = 1,50,00,000 × 14% = ₹21,00,000. Z RI = 30,00,000 − 21,00,000 = ₹9,00,000.
Z ranks higher on both measures: higher ROI and higher RI.
Comment: both earn above the 14% cost of capital so both add value. Y is much larger, yet its RI is lower, showing its return is only just above the required rate.

Answer: Y: ROI 15%, RI ₹6,00,000. Z: ROI 20%, RI ₹9,00,000. Z performs better on both measures, though both divisions exceed the 14% cost of capital.

Exam tips

Write the formulas first, then substitute. Method marks in Section C depend on clear working.
In objective test questions, check whether the question asks what the manager would do or what is best for the group. The answers differ.
Keep the profit and capital employed definitions exactly as given, including whether to use opening or closing values.
For discussion parts, link each point to behaviour: ROI discourages investment above the cost of capital but below current ROI; RI encourages it.
Mention at least one limitation of each measure, such as the size problem with RI and book value distortion with both.

Practice questions from Divisional performance and transfer pricing

Divisional Performance Measures: ROI and Residual Income in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Divisional Performance Measures: ROI and Residual Income: frequently asked questions

What is the difference between ROI and residual income?

ROI is a percentage: profit divided by capital employed. Residual income is a money amount: profit less a capital charge at the cost of capital. RI tends to give better goal congruence, while ROI is easier to compare across divisions of different sizes.

How do I calculate residual income in ACCA PM?

Multiply capital employed by the cost of capital to get the capital charge. Subtract it from divisional profit. Use the profit and capital definitions the question gives.

What is dysfunctional behaviour under ROI?

It is when a manager makes a choice that helps their own ROI but harms the group. For example, rejecting a project that earns more than the cost of capital because it earns less than the division's current ROI.

Can residual income be negative?

Yes. A negative RI means the division earns less than the required return on its capital. It signals that the division is not covering its capital charge.