The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing the performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division.

**Investment centres**

In an investment centre, managers have the responsibilities of a profit centre plus responsibility for capital investment. Two measures of divisional performance are commonly used:

1 Return on investment (ROI) =

controllable (traceable) profit %

controllable (traceable) investment

2 Residual income = controllable (traceable) profit - an imputed interest charge on controllable (traceable) investment.

Example 3 demonstrates their calculation and some of the drawbacks of return on investment.

**Example 3**

Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of $2.2m per annum. Division X's cost of capital is 10% per annum. The division is considering two proposals.

Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m.

Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a reduction in profits of $0.3m.

Proceeds from the disposal of assets would be credited to head office not Division X.

Required: calculate the current ROI and residual income for Division X and show how they would change under each of the two proposals.

Current situation

Return on investment

ROI = $2.2m = 22%

$10.0m

Residual income

Profit $2.2m

Imputed interest charge

$10.0m x 10% $1.0m

Residual income $1.2m

Comment: ROI exceeds the cost of capital and residual income is positive. The division is performing well.

Proposal 1

Return on investment

ROI = $2.35m = 21.4% $11.0m

Residual income

Profit $2.35m

Imputed interest charge

$11.0m x 10% $1.1m

Residual income $1.25m

Comment: In simple terms the project is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting proposal 1. This would be a dysfunctional decision. Residual income increases if proposal 1 is adopted and this performance measure should lead to goal congruent decisions.

Proposal 2

Return on investment

ROI = $1.9m = 24.7% $7.7m

Residual income

Profit $1.90m

Imputed interest charge

$7.7m x 10% $0.77m

Residual income $1.13m

Comment: In simple terms the disposal is not acceptable to the company. The existing assets have a rate of return of 13.0% ($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting proposal 2. This would be a dysfunctional decision. Residual income decreases if proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions.

**Relative merits of ROI and residual income**

Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow £100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%?

Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of $15 per annum after borrowing costs. The bigger investment would give a net return of $50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth.

Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth. Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance.

**Problems common to both ROI and residual income**

The following problems are common to both measures:

- Identifying controllable (traceable) profits and investment can be difficult.
- If used in a short-term way they can both overemphasise short-term performance at the expense of long-term performance. Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to rejection of projects by managers (see Example 4).
- If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery (see Example 4).
- Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern businesses, multi-faceted measures of performance are necessary.
- Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.