PERFORMANCE EVALUATION OF BUSINESS UNITS 199
taken out, that was relevant. The investment value, according to Solomons, should
be total assets less controllable liabilities, with fixed assets valued at cost using the
value at the beginning of the period. ROI calculations therefore relate controllable
operating profit as a percentage of controllable investment. An RI approach would
measure net residual income plus actual interest expense (because the notional
cost of capital has been deducted in calculating RI) against the total investment in
the division.
The following case study provides an example of divisional performance
measurement using ROI and RI techniques.
Case study: Majestic Services – divisional performance measurement
Majestic Services has two divisions, both of which have bid for £1 million for
projects that will generate significant cost savings. Majestic has a cost of capital of
15% and can only invest in one of the projects.
The current performance of each division is as follows:
Division A Division B
Current investment £4 million £20 million
Profit £1 million £2 millionEach division has estimated the additional controllable profit that will be generated
from the £1 million investment. A estimates £200,000 and B estimates £130,000.
Each division also has an asset of which they would like to dispose. A’s asset
currently makes a return on investment (ROI) of 19%, while B’s asset makes an
ROI of 12%. The business wishes to use ROI and residual income techniques to
determine in which of the £1 million projects Majestic should invest, and whether
either of the division’s identified assets should be disposed of.
Using ROI, the two divisions can be compared as in Table 13.1. While Division
B is the larger division and generates a higher profit in absolute terms, Division A
achieves a higher return on investment.
Again using ROI, the impact of the additional investment can be seen in
Table 13.2. Using ROI, Division A may not want its project to be approved as the
ROI of 20% is less than the current ROI of 25%. The impact of the new investment
would be to reduce the divisional ROI to 24% (£1.2 million/£5 million). However,
Division B would want its project to be approved as the ROI of 13% is higher
Table 13.1 ROI on original investment
AB
Current investment £4 million £20 million
Current profit £1 million £2 million
ROI 25% 10%