Advanced Performance Management · Financial performance measurement

Limitations of Financial Performance Measures in ACCA APM

Updated 11 October 2026 · Fact-checked

Financial performance measures such as ROI, residual income and profit show past results in money terms. Their limitations are short-termism, distortion by accounting policies, manipulation by managers, and no view of quality, customers, people or the future. To answer, name the limit, apply it to the scenario, then recommend balancing measures.

Understand Limitations of Financial Performance Measures

A financial performance measure turns results into a number in money terms. Examples are profit, revenue growth, return on investment (ROI), residual income (RI) and earnings per share. They are useful because they are objective, comparable and linked to what owners care about.

The problem is that they are lagging indicators. They report what has already happened. They say little about why results occurred or what will happen next. A company can post good profit this year while its brand, staff morale and product pipeline decline.

Short-termism means managers focus on results in the current period at the cost of long-term value. If a manager's bonus depends on this year's profit or ROI, cutting training, R&D, marketing or maintenance raises profit now. The damage appears later. ROI adds a further twist: a division with high ROI may reject a project that earns more than the group's cost of capital but less than the division's current ROI. That is dysfunctional behaviour because it is good for the manager but bad for the group.

Accounting distortions come from the way figures are built. Depreciation methods, inventory valuation, capitalising or expensing costs, and inflation all change profit and capital employed. Old assets with low net book value flatter ROI. As assets age, ROI rises even though nothing improves. Different divisions or firms may use different policies, so comparison is unreliable. Transfer prices and allocated head office costs can also distort divisional profit.

Manipulation (creative accounting) is when managers choose timing or policies to hit targets. Examples are delaying expenses, accelerating revenue, cutting discretionary spending near year end, or delaying asset purchases to keep capital employed low. Some of this is legal but still unethical or harmful. Weak controls and bonus pressure make it more likely.

Finally, financial measures give an incomplete picture. They ignore customer satisfaction, quality, innovation, employee skills, environmental impact and stakeholder interests. This is why frameworks such as the balanced scorecard add non-financial measures. In the exam, show you can both criticise financial measures and suggest practical fixes.

Key rules to remember

Return on investment (ROI): ROI = Divisional profit ÷ Capital employed × 100%; Define profit and capital employed in your answer, for example controllable profit and net assets. Say which version you use.
Residual income (RI): RI = Divisional profit − (Capital employed × Cost of capital); Positive RI means the division earns more than the required return. It is an absolute figure, so it favours larger divisions.
Decision rule for ROI: Accept a project if its return > the group's cost of capital (group view). A division using ROI accepts only if project ROI > current divisional ROI.; The mismatch between these two rules is the main cause of dysfunctional decisions under ROI.
Decision rule for RI: Accept a project if it gives positive RI, that is, return > cost of capital; This matches the group view, assuming the cost of capital is set appropriately.

How to solve Limitations of Financial Performance Measures questions

Use this method for any question asking you to discuss, criticise or evaluate financial performance measures.

1Read the requirement and note the verb (discuss, evaluate, recommend) and who you are advising.
2Identify which measures the scenario uses (ROI, RI, profit, EPS, budget targets) and how managers are rewarded.
3List the relevant limitations in groups: short-termism, accounting distortion, manipulation, lack of non-financial and strategic view.
4Apply each limitation to the facts. Quote figures or behaviours from the scenario and explain the likely effect.
5If numbers are given, calculate ROI and RI and show the conflicting signals, for example a project that raises RI but lowers ROI.
6Evaluate: say which limitations matter most here and why. Note that financial measures still have value.
7Recommend fixes: add non-financial measures, use RI or EVA, use longer-term targets, tighten controls, and review reward design.
8Finish with a short conclusion that answers the requirement, in the format requested, for professional skills marks.

Quickest way: Four-box scan: short-term, distortion, manipulation, missing view

When to use it: Use when time is short, such as a 10 to 15 mark discussion part in Section B or a short requirement in the case study.

Draw four boxes in your plan: short-termism, distortion, manipulation, missing view.
Pick one fact from the scenario for each box.
Write one or two sentences per box: the limitation, the scenario fact, the consequence.
Add a final box for fixes: balanced measures, RI or EVA, long-term rewards, controls.
Check that you have a conclusion that answers the question asked.

Common mistakes in Limitations of Financial Performance Measures

Listing generic limitations without applying them to the scenario.
Students memorise a list and write it out. It feels safe.
Fix: For every point, add a fact from the case and its consequence. Marks go to application, not lists.
Saying ROI is bad and RI is perfect.
Textbooks often present RI as the fix for ROI.
Fix: Show that RI also has limits: it favours large divisions, depends on how capital employed and the cost of capital are measured, and uses the same accounting data.
Confusing short-termism with manipulation.
Both involve managers acting for their own benefit.
Fix: Short-termism is a real decision that sacrifices future value, such as cutting R&D. Manipulation is changing the reported numbers through timing or policy choices. Say which one applies.
Forgetting that a high ROI can come from ageing, depreciated assets.
Students treat the ROI figure as a pure sign of efficiency.
Fix: Check asset age and net book value. Note that rising ROI may just reflect depreciation and that comparisons between divisions can mislead.
Recommending non-financial measures with no detail.
Students write 'use the balanced scorecard' and stop.
Fix: Name specific measures linked to the problem, such as customer complaints, staff turnover or time to market, and explain how they offset the limitation.
Ignoring the ethical angle when manipulation is hinted at.
Students focus on technical analysis only.
Fix: Comment on integrity, the role of controls and audit, and the effect of reward schemes. Show professional scepticism.

Worked examples

Example 1

Division A of a group has profit of $600,000 and capital employed of $3,000,000. The group's cost of capital is 12%. The divisional manager is paid a bonus based on ROI. A new project needs $500,000 and would earn annual profit of $75,000. Calculate the effect on ROI and RI, say what the manager will probably do, and explain the problem.

Show the solution

Current ROI = 600,000 ÷ 3,000,000 = 20%.
Project return = 75,000 ÷ 500,000 = 15%.
New ROI with project = (600,000 + 75,000) ÷ (3,000,000 + 500,000) = 675,000 ÷ 3,500,000 = 19.29% (approximately). ROI falls from 20%.
Current RI = 600,000 − (3,000,000 × 12%) = 600,000 − 360,000 = $240,000.
RI with project = 675,000 − (3,500,000 × 12%) = 675,000 − 420,000 = $255,000. RI rises by $15,000. Check: project RI = 75,000 − (500,000 × 12%) = 75,000 − 60,000 = $15,000.
The project return of 15% is above the 12% cost of capital, so it adds value to the group.
A manager judged on ROI sees ROI fall and will probably reject the project.
This is dysfunctional behaviour (goal incongruence): the manager's decision is not in the group's interest. It is a form of short-termism because the manager protects this year's ROI at the cost of future value.
Recommend using RI, or ROI with a comparison to the cost of capital. Add non-financial targets and a longer-term reward measure.

Answer: ROI falls from 20% to about 19.29% while RI rises from $240,000 to $255,000. The project is worth accepting for the group, but an ROI-driven manager will likely reject it. Using RI aligns the decision with group value.

Example 2

A retail company's store managers receive a bonus if annual operating profit exceeds budget. In the last quarter, one store cut staff training and delayed shop refits, and asked suppliers to invoice in the new year. Profit exceeded budget. Discuss the limitations of the profit measure that this shows.

Show the solution

Identify the measure and the incentive: operating profit versus budget, with a bonus attached.
Short-termism: cutting training and delaying refits reduces costs now. The effects, such as poorer service, weaker store appearance and lower sales, will appear in later years. Profit this year is higher at the cost of future value.
Manipulation: asking suppliers to invoice in the new year moves expenses into the next period. This flatters current profit without any real improvement. It may breach accruals principles if goods have already been received.
Accounting distortion: annual profit is based on accounting rules and timing, so it does not show underlying performance or customer experience.
Missing view: profit says nothing about customer satisfaction, staff skills or store condition. These are the drivers of future profit.
Ethical point: if costs were deliberately deferred, this raises integrity concerns and needs investigation by internal audit or finance.
Recommendations: add non-financial measures such as customer satisfaction, staff turnover and training hours. Use cut-off checks, and base part of the bonus on multi-year performance.

Answer: The profit-versus-budget measure encourages short-termism (cutting training and refits) and manipulation (shifting costs into the next period). It also ignores drivers of future performance. Balanced measures, stronger controls and longer-term rewards would reduce these problems.

Exam tips

Always tie each limitation to a fact in the scenario. Generic lists score poorly in APM.
When numbers are given, calculate both ROI and RI. Then comment on the conflict between them.
Separate short-termism, distortion and manipulation clearly. Examiners reward precise use of terms.
Do not stop at criticism. Offer practical remedies and a balanced conclusion to earn professional skills marks.
If the scenario hints at pressure on managers, add a brief note on ethics and control.

Practice questions from Financial performance measurement

Limitations of Financial Performance Measures in other exams

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

Limitations of Financial Performance Measures: frequently asked questions

What is short-termism in performance management?

It is when managers focus on current-period results at the expense of long-term value. A common cause is a bonus tied to annual profit or ROI. Examples are cutting R&D, training or maintenance to lift this year's profit.

Why can ROI lead to poor decisions?

A manager judged on ROI may reject a project that earns more than the cost of capital but less than the division's current ROI. This helps the manager but harms the group. Residual income avoids this problem because it accepts any project with a return above the cost of capital.

What is creative accounting in APM?

It means managers use accounting choices or timing to reach targets, such as delaying expenses or bringing revenue forward. It does not improve real performance. Strong controls, audit and balanced reward schemes reduce it.

Does residual income solve all the problems of ROI?

No. It removes the mismatch in project decisions, but it favours larger divisions because it is an absolute amount. It also relies on accounting figures and on a suitable cost of capital, so distortions can remain.