ExpertMedium2 marksMultiple Choice
ACCA · Question 31 · Performance measurement
Section A
A heavy mining corporation evaluates its divisional managers using Return on Investment (ROI). The board is considering switching to Residual Income (RI).
What is the primary advantage of using RI instead of ROI for divisional performance measurement?
Section A
A heavy mining corporation evaluates its divisional managers using Return on Investment (ROI). The board is considering switching to Residual Income (RI).
What is the primary advantage of using RI instead of ROI for divisional performance measurement?
Answer options:
A.
RI is a percentage, making it easier to compare divisions of different sizes.
B.
RI ignores the cost of capital, making it simpler to calculate.
C.
RI reduces the risk of dysfunctional decision-making where managers reject profitable projects that lower their average ROI.
D.
RI completely eliminates the need to value the division's asset base.
How to approach this question
Think about the behavioral flaw of ROI: a manager with a 20% ROI will reject a 15% project, even if the company's cost of capital is only 10%. RI fixes this.
Full Answer
C.RI reduces the risk of dysfunctional decision-making where managers reject profitable projects that lower their average ROI.✓ Correct
A major flaw of ROI is dysfunctional behavior: a manager with a high current ROI might reject a new project that exceeds the company's cost of capital but is lower than their current ROI, because it would drag their average down. Residual Income (RI) solves this. Since RI is an absolute measure (Profit - Imputed Interest), any project returning more than the cost of capital will increase total RI, encouraging managers to accept it.
Common mistakes
Believing RI is a percentage measure, which makes it easier to compare sizes (this is the advantage of ROI, not RI).
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