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ACCA Strategic Professional · Advanced Performance Management · Financial performance measurement

Kestrel Ltd reports operating profit of $2.4m, capital employed of $12m and a cost of capital of 8%. Its divisional manager rejects a project earning a 15% return because it would lower the division's current ROCE of 20%. Which measure would best remove this dysfunctional behaviour?

Residual income best removes the problem because it deducts a charge for capital at the cost of capital. A project earning 15% against an 8% cost of capital increases residual income, so the manager accepts it even though divisional ROCE falls.

  1. AResidual incomeCorrect
  2. BGross profit margin
  3. CEarnings per share
  4. DAsset turnover

Explanation

ROCE encourages managers to reject projects earning above the cost of capital but below the current ROCE. Residual income deducts a capital charge, so a 15% project against an 8% cost of capital adds value and would be accepted. Margin, EPS and asset turnover do not charge for capital in this way.

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