PERFORMANCE EVALUATION OF BUSINESS UNITS 197
with this approach is whether a high rate of return on a small capital investment
is better or worse than a lower return on a larger capital. For example:
Div A Div B
Capital invested £1,000,000 £2,000,000
Operating profit £200,000 £300,000
Return on investment 20% 15%Division B makes a higher profit in absolute terms but a lower return on the capital
invested in the business. Solomons (1965) also argued that a decision cannot be
made about relative performance unless we know the cost of capital.
Residual income
A different approach to evaluating performance is residual income, which takes
into account the cost of capital.Residual income(orRI) is the profit remaining
after deducting the notional cost of capital from the investment in the division. The
RI approach was developed by the General Electric Company and more recently
has been compared with Economic Value Added (EVA, see Chapter 2), as both
methods deduct a notional cost of capital from the reported profit. Using the
above example:
Div A Div B
Capital invested £1,000,000 £2,000,000
Operating profit £200,000 £300,000
less cost of capital at 17.5% £175,000 £350,000Residual income £25,000 −£50,000As the cost of capital is 17.5% in the above example, Division A makes a satisfactory
return but Division B does not. Division B is eroding shareholder value while
Division A is creating it.
The aim of managers should be to maximize the residual income from the
capital investments in their divisions. However, Solomons (1965) emphasizes
that the RI approach assumes that managers have the power to influence the
amount of capital investment. Solomons argued that an RI target is preferred to a
maximization objective because it takes into account the differential investments
in divisions, i.e. that a larger division will almost certainly produce – or should
produce – a higher residual income. Johnson and Kaplan (1987) believe that the
residual income approach:
overcame one of the dysfunctional aspects of the ROI measure in which
managers could increase their reported ROI by rejecting investments that
yielded returns in excess of their firm’s (or division’s) cost of capital, but that
were below their current average ROI. (p. 165)