Performance Measurement

Question 1

What are the three measures used for DIVISIONAL Performance?

Answer 1

• ROI
• RI
• EVA

Question 2

What is ROI?

Answer 2

• Equivalent to ARR
• Expresses divisional profit as a percentage of the assets employed in a division

Question 3

Advantages of ROI?

Answer 3

• Easy to use and understand e.g. expressed in percentage terms

Question 4

Disadvantages of ROI?

Answer 4

• Encourages a focus on short-term results
• Discourages investment in new assets
• Problems of accounting policies in measuring income

Question 5

What is Residual Income (RI)?

Answer 5

• Controllable profit less a cost of capital charge on the investment controllable by the divisional manager
• Used to overcome some of the dysfunctionalities of ROI

Question 6

Residual Income (RI) Advantages:

Answer 6

• Investments will be made if the return exceeds the hurdle rate (min rate expected)
• Required rates of return can be adjusted for different levels of risk

Question 7

Disadvantages of RI:

Answer 7

• Not useful for units of different sizes as it tends to favour large divisions

Question 8

What is Economic Value Added (EVA)?

Answer 8

EVA = conventional division profit +/- accounting adjustments - cost of capital charge on divisional assets

Question 9

Advantages of EVA:

Answer 9

• Capitalises certain expenses that contribute to long-term value of the firm when measuring income - so not subject to conventional accounting policies
• Focuses managers attention on creating value for shareholders in the long-run

Question 10

Disadvantages of EVA:

Answer 10

• Managers’ perception of the cost of capital subject to capital restructuring decisions and market whims/ expectations