Accounting Business Reporting for Decision Making

CHAPTER 14 Performance measurement 577

ILLUSTRATIVE EXAMPLE 14.5

Residual income

In   our     example,   the  RI  for     each   of   the     three  divisions   (assuming   a    required   rate     of  return of   15  per     cent)  

would be as follows:

Division RI

Corporate $ 400 000 − (0.15 × $2 200 000) = $70 000

Department stores −$ 70 000 − (0.15 × $75 000) = –$81 250

Specialty stores $ 70 000 − (0.15 × $225 000) = $36 250

The above calculations indicate that, after a suitable charge for capital, the corporate division is con-

tributing $70 000 and the specialty stores division is contributing $36 250. The department stores div-

ision is not contributing enough to cover the charge for capital, which is 15 per cent. Remember that

the  ROI     for     the     corporate  division    is   18.2   per  cent,  31.1    per  cent   for  the     specialty  stores  division    and 

–93.3 per cent for the department stores division. Consideration needs to be given to the suitability of

the 15 per cent expected return in the current economic climate. That is, how does this return compare

with     other  investment  alternatives?   It   may    be   that    the     attainment of   a   15  per     cent   return  in   the     current    

economic climate is reasonable given the level of risk associated with the investment.

Revisiting the investment opportunity presented earlier for the specialty stores division, the use of

RI   would  result  in   the     specialty  stores  division    accepting   the  investment opportunity of   expanding  to  

another geographic area. Recall that the expansion would require an additional $50 000 investment and

was predicted to contribute $12 500 to the entity. The residual income would be:

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

= ($70 000 + $12 500) – [15% × ($225 000 + $50 000)]

= $41 250

This is an increase of $5000 on the current residual income of $36 250, so the manager of the specialty

stores division would accept the investment opportunity.

Using RI as a performance indicator has the following advantages.

• It minimises the suboptimal decision making that could result from the use of ROI. A manager would

take on a new investment opportunity if the dollar return was greater than the charge for the extra

capital invested.

• The charge for capital can vary across divisions based on the risk of the venture being pursued in each

division.

Using RI as a performance indicator has the following disadvantages:

• It can still encourage short-term decision making.


• The required rate of return or a suitable charge for capital may not be easy to determine.

Economic value added

Economic value added (EVA®)^1 was developed by the company Stern Stewart & Co, and is a registered

trademark. Like residual income, this measure is based on the economic increase in an organ isation’s

value after a suitable charge for capital is subtracted. The formula for economic value added is as follows.

EVA = Profit after tax (PAT) − (Cost of capital × Capital)

Compare this formula to the residual income formula presented earlier.

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

(^1) EVA is a registered trademark of Stern Stewart & Co. More information can be found at http://www.sternstewart.com.