Divisional Performance: ROI and Residual Income Explained

Understand Divisional Performance: ROI and Residual Income

Key rules to remember

Return on Investment

ROI = (Divisional profit ÷ Capital employed) × 100

Use the profit and capital definitions given in the question. Use closing, opening or average capital only as instructed.

Residual Income

RI = Divisional profit − (Capital employed × Required rate of return)

The deduction is a notional capital charge. It is not the interest actually paid.

Capital charge

Capital charge = Capital employed × Required rate of return

Calculate this first, then subtract.

ROI decision rule

Accept if project ROI > required rate of return

Divisions often compare with their current ROI instead, which causes the conflict.

RI decision rule

Accept if RI is positive (project return > required rate)

Zero RI means the return exactly equals the required rate.

EVA

EVA = NOPAT − (Invested capital × WACC)

NOPAT is net operating profit after tax. Adjustments apply only if the question gives them.

How to solve Divisional Performance: ROI and Residual Income questions

1. 1Identify the profit measure the question gives (controllable or divisional profit) and the investment base (capital employed, total assets, average or closing).
2. 2Check for adjustments: remove items not controllable by the manager, such as allocated head office costs, if the question says so.
3. 3Compute ROI = profit ÷ capital × 100 for each division or for before and after a project.
4. 4Compute the capital charge = capital × required rate, then RI = profit − capital charge.
5. 5For a new project, recompute the division's profit and capital with the project included, then compare ROI and RI before and after.
6. 6State the decision under each measure. If ROI and RI disagree, say so and explain why.
7. 7Add a one-line comment: RI aligns manager goals with company goals; ROI may cause rejection of good projects.

Quickest way: Project test with the hurdle rate

Common mistakes in Divisional Performance: ROI and Residual Income

• Deducting actual interest paid instead of a capital charge on total capital employed.

  Students confuse notional charge with the interest expense in the profit statement.

  Fix: Always multiply total capital employed by the required rate. Ignore actual interest unless told otherwise.

• Showing RI as a percentage.

  RI is confused with ROI.

  Fix: Show RI as a rupee amount. Only ROI is a percentage.

• Comparing project ROI with current divisional ROI and calling it the correct company decision.

  Managers behave this way, so students assume it is right.

  Fix: For the company, compare project return with the cost of capital. Mention the divisional view separately.

• Mixing profit before and after interest or tax with the capital base.

  Students ignore the definitions given in the question.

  Fix: Underline the profit and capital definitions in the question and use them consistently.

• Adding a project's investment to capital but forgetting to add its profit.

  Rushing in before and after calculations.

  Fix: Write a small table: existing, project, combined. Fill profit and capital for each.

• Writing limitations without linking to behaviour.

  Students list points from memory.

  Fix: Explain the effect: ROI discourages investment by high-return divisions, encourages short-term thinking and may be distorted by depreciated old assets.

Worked examples