Accounting Business Reporting for Decision Making

576 Accounting: Business Reporting for Decision Making

It is useful to conduct the above analysis on divisions and other entities in similar industries to

ascertain good performance and to point to possible improvements. For instance, comparing the

profit margin of the corporate and specialty stores divisions (40.4 per cent compared to 13.46 per

cent) indicates that the prices in the specialty stores division might be too low or its operating

costs too high. Further, comparing the asset turnover of the corporate and specialty stores divisions

(0.45 times compared to 2.31 times) suggests that the assets in the corporate division are not gen-

erating enough sales. Therefore, assets (e.g. cash, inventory, receivables, equipment, property) may

need to be reduced.

Using ROI as a performance indicator has the following advantages.

• ROI is easy to use and understand.


• It links profit with the investment base, thereby increasing awareness of asset management and dis-

couraging overinvestment.

• The relationship between assets held on the balance sheet and the profit in the statement of profit or

loss can be easily linked.

Using ROI as a performance indicator has the following disadvantages.

• ROI is a percentage measure, not a measure of absolute values. For instance, the ROI calculations

above indicated that the specialty stores division was a better performer than the corporate division,

yet the corporate division contributed $400 000 while the specialty stores division contributed $70 000.

Therefore, ROI should not be used as the sole measure of performance.

• ROI does not consider divisions that are different in size or type. Comparisons for performance evalu-

ation are useful only if made between divisions of similar size and type.

• Divisional managers can manipulate ROI by decreasing the investment base relative to the segment

profit. For example, managers might delay investing in new equipment that would increase the invest-

ment base (the denominator), or might purchase cheaper, substandard equipment. The use of ageing or

suboptimal equipment might increase ROI in the short term but could be detrimental to performance

in the long term.

• ROI use could result in suboptimal decision making. Managers might reject an investment

opportunity because it could decrease overall ROI. For example, assume the specialty stores div-

ision has an opportunity to expand into another geographical market with an investment require-

ment of $50 000 and an expected segment return of $12 500. The expected ROI of this expansion

would be 25 per cent, and the existing ROI for the corporate division of 31.1 per cent would be

reduced to 30 per cent by this new investment. The reduction in the ROI might make the manager

reluctant to take on the investment even though it would have a positive impact on the company

overall.

The disadvantages discussed above result from ROI being a short-term performance measure. There

is a need to include long-term performance measures in combination with the ROI when assessing

performance.

Residual income

The formula for residual income (RI) is

Residual income (RI) = Profit before tax − (Required rate of return × Investment)

Unlike the ROI, the residual income method is expressed in absolute dollars. An examination of the

RI formula shows that a charge for capital (that is, the required rate of return) is subtracted from the

divisional contribution. This alleviates the problem of managers making suboptimal decisions based on a

decrease in ROI. The use of a suitable charge based on the organisation’s expected returns will result in

managers accepting investment opportunities that give an ROI that is higher than the charge for capital.

The calculation of residual income is demonstrated in illustrative example 14.5.