Advanced Performance Management · Financial performance measurement

Divisional Performance: ROI, Residual Income and EVA

Updated 11 October 2026 · Fact-checked

ROI is divisional profit divided by capital employed, shown as a percentage. Residual income is profit minus a charge for capital, shown as a money amount. EVA is residual income built on adjusted after-tax profit and adjusted capital. Compute each one, then explain how it affects investment decisions and manager behaviour.

Understand Divisional Performance: ROI, Residual Income and EVA

A company with divisions needs a way to judge each division and its manager. Profit alone ignores the size of the investment behind it. A division earning $1m on $2m of capital is doing far better than one earning $1m on $20m. So we relate profit to capital.

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 behavioural. A manager is judged on the percentage, so a manager with a high ROI may reject a project that earns well above the cost of capital but below the division's current ROI. That harms the group. A manager with a low ROI may accept projects that earn more than the division average but less than the cost of capital.

Residual income (RI) fixes this. It deducts a capital charge (capital employed × required rate of return) from profit. Any project that earns more than the required return raises RI, so the manager and the group want the same decisions. RI gives a money figure, so it is harder to compare divisions of different sizes. It also depends on the rate chosen.

Economic value added (EVA) is a version of RI from Stern Stewart. It starts from net operating profit after tax (NOPAT) and charges the weighted average cost of capital (WACC) on economic capital employed. It adjusts accounting figures that distort economic reality. Typical adjustments treat spending that creates future benefit, such as research and development, advertising or training, as an investment rather than an expense. The aim is to reduce short-termism and move profit closer to real value created.

In APM you are rarely asked only to calculate. You must also say what behaviour each measure encourages, whether it fits the scenario, and what its limits are, such as reliance on accounting data, short-term focus and controllability of the figures.

Key rules to remember

Return on investment: ROI = Divisional profit ÷ Capital employed × 100%; State which profit and which capital you use. Use controllable profit for the manager and traceable profit for the division. Be consistent in the numerator and denominator.
Residual income: RI = Divisional profit − (Capital employed × Required rate of return); Profit is usually before interest, because the capital charge already covers the cost of finance. The answer is in money.
Economic value added: EVA = NOPAT − (WACC × Economic capital employed); NOPAT is adjusted operating profit less tax. Economic capital is net assets plus the adjustments, such as capitalised R&D.
Project decision rules: ROI rule: accept if project return > division's current ROI. RI/EVA rule: accept if project return > required return or WACC (RI/EVA rises).; The mismatch between these rules is the core behavioural point examiners test. The rule matching the group's interest is the second.
Capital employed basis: Capital employed = Total assets − Current liabilities (or net assets, as stated in the question); Follow the question. Using opening, closing or average capital changes the answer, so say which one you used.

How to solve Divisional Performance: ROI, Residual Income and EVA questions

Use this order for any question on divisional performance measures. It covers both the calculation and the discussion that earns the marks.

1Read the requirement. Note whether you must calculate, evaluate, recommend or advise on behaviour. Note the currency and the cost of capital given.
2Decide the profit figure. Use the one given for the division and check whether interest, tax or head office charges must be removed or added. Use controllable profit if you are judging the manager.
3Decide the capital figure. Use net assets or capital employed as stated, and apply any adjustments for EVA, such as adding back capitalised R&D. Say whether you use opening, closing or average.
4Calculate ROI, RI or EVA as required. Show the capital charge line separately so a marker can follow your working.
5If a new project is involved, calculate the effect on each measure before and after. Compare the project return with the current ROI and with the required return.
6Interpret the numbers. Say which division performs better on each measure and why the rankings may differ.
7Explain the behaviour each measure encourages: rejecting good projects under ROI, taking more investment under RI, short-term cuts under EVA if the adjustments are ignored.
8Conclude with a recommendation. Mention limits such as the choice of rate, use of historical cost, non-financial factors and the need for a balanced scorecard. Link every point to the scenario.

Quickest way: Three-line test for any project

When to use it: Use when the question asks whether a manager would accept a project and whether the group would want it accepted.

Compute the project return: project profit ÷ project investment.
Compare it with the current divisional ROI, to predict the ROI-driven decision.
Compare it with the required return or WACC, to predict the RI or EVA decision, which is also the group's right decision.
If the two comparisons point in opposite directions, you have a goal congruence problem. Say so, give both calculations, and recommend RI or EVA as the better decision rule.

Common mistakes in Divisional Performance: ROI, Residual Income and EVA

Deducting interest from profit before calculating RI.
Students are used to profit after interest from the income statement.
Fix: The capital charge already covers the cost of finance, so use profit before interest. Check what the question gives and adjust.
Comparing RI figures of divisions of different sizes as if they showed efficiency.
RI is in money, so the bigger division almost always looks better.
Fix: Say that RI is not good for size comparison. Use ROI alongside it, or compare each division with its own target.
Forgetting to add the same adjustments to both profit and capital in EVA.
Students add back R&D to profit but leave capital unchanged.
Fix: If you capitalise an item, add it to profit (less amortisation) and add the unamortised balance to capital. Then tax the adjusted profit.
Stopping at the calculation and not discussing behaviour.
The numbers feel like the whole answer.
Fix: Every calculation should be followed by a sentence on what decision the manager would make and whether the group would agree. Many marks are for application.
Using the wrong rate: the company rate, the division's own ROI or a cost of debt.
Several rates appear in the scenario.
Fix: Use the rate stated for the capital charge, usually WACC or a divisional required return. Mention that different divisions may have different risk and so different rates.
Calling EVA a perfect measure.
It is presented as the improvement on RI.
Fix: Note that it still uses historical accounting data, needs a WACC estimate, involves many subjective adjustments and is short-term unless combined with non-financial measures.

Worked examples

Example 1

Division A earns controllable profit of $1,200,000 on capital employed of $6,000,000. The group cost of capital is 12%. Division A can invest $1,000,000 in a project that earns a profit of $170,000 a year. Calculate ROI and RI before and after the project. State whether the manager, judged on ROI, would accept it and whether the group should.

Show the solution

Before the project, ROI = 1,200,000 ÷ 6,000,000 = 20%.
Before the project, RI = 1,200,000 − (6,000,000 × 12%) = 1,200,000 − 720,000 = $480,000.
Project return = 170,000 ÷ 1,000,000 = 17%.
After the project, profit = 1,200,000 + 170,000 = $1,370,000 and capital employed = 6,000,000 + 1,000,000 = $7,000,000.
After the project, ROI = 1,370,000 ÷ 7,000,000 = 19.6% (to one decimal place).
After the project, RI = 1,370,000 − (7,000,000 × 12%) = 1,370,000 − 840,000 = $530,000.
RI rises by $50,000, which equals 170,000 − (1,000,000 × 12%) = 170,000 − 120,000.
The project return of 17% is below the current ROI of 20%, so ROI falls and an ROI-driven manager would reject it. The 17% return is above the 12% cost of capital, so RI rises and the group gains.

Answer: Before: ROI 20%, RI $480,000. After: ROI 19.6%, RI $530,000. An ROI-driven manager would reject the project, but the group should accept it because it earns 17% against a 12% cost of capital. This is a goal congruence problem, and RI would remove it.

Example 2

Division B reports operating profit of $3,000,000 and net assets of $14,000,000. During the year it expensed $400,000 of research and development that creates future benefit. Capitalised R&D from earlier years is amortised at $250,000 this year. The unamortised net balance of capitalised R&D, after this year's amortisation, is $900,000. The tax rate is 25% and WACC is 10%. Calculate EVA using these adjustments.

Show the solution

Adjusted operating profit = 3,000,000 + 400,000 (R&D added back) − 250,000 (amortisation) = $3,150,000.
Tax at 25% = 3,150,000 × 25% = $787,500. Assume tax is charged on the adjusted profit.
NOPAT = 3,150,000 − 787,500 = $2,362,500.
Economic capital employed = 14,000,000 + 900,000 = $14,900,000.
Capital charge = 14,900,000 × 10% = $1,490,000.
EVA = 2,362,500 − 1,490,000 = $872,500.

Answer: EVA is $872,500 positive, so Division B creates value after covering the cost of all capital. State the assumptions: tax on adjusted profit and the R&D treatment. Note that without the adjustments the manager's incentive would be to cut R&D to lift profit.

Exam tips

Show the capital charge on its own line in RI and EVA. Even if you pick a wrong figure, the method marks are safe.
State your assumptions on profit, capital basis and tax when the scenario is silent. Markers accept a reasonable assumption if it is stated and used consistently.
When asked to evaluate, compare at least two measures and link each to a manager behaviour in the scenario. Generic textbook points score poorly.
Use the professional skills marks: give a clear recommendation, challenge the data (controllable versus allocated costs, risk differences) and communicate in the format asked.
Link to wider issues when relevant: short-termism, transfer prices distorting divisional profit, and different risk and currency in overseas divisions.

Practice questions from Financial performance measurement

Divisional Performance: ROI, Residual Income and EVA 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: ROI, Residual Income and EVA: frequently asked questions

What is the main difference between ROI and residual income?

ROI gives a percentage return, so it can push managers to reject projects that earn less than their current ROI but more than the cost of capital. Residual income gives a money amount after a capital charge, so any project earning above the required return increases it. RI therefore aligns manager and group decisions better.

How do I calculate EVA in APM?

Calculate NOPAT as adjusted operating profit less tax, then deduct WACC multiplied by economic capital employed. Make the same adjustments to profit and capital, for example adding back R&D and including its unamortised balance in capital. Show each step and state your assumptions.

Is EVA the same as residual income?

They are the same idea: profit less a charge for capital. EVA is more specific. It uses after-tax operating profit, WACC and accounting adjustments to get nearer to economic profit, while RI often uses accounting profit and a stated required return.

Should I use opening, closing or average capital employed?

Use whatever the question specifies. If it does not say, choose one, state it and apply it consistently. Average capital is often the fairest for the year, but the key marks are for being clear and consistent.