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Performance Measurement and ControlDivisional PerformanceROI vs RISyllabus Area E

ACCA · Question 13 · Performance Measurement and Control

Section A

A multinational retail chain evaluates its divisional managers based on Return on Investment (ROI). Division X currently has an ROI of 18%. The company's cost of capital is 12%.
Division X's manager is considering a new project that yields a return of 15%.

What is the likely behavioral outcome of using ROI for this decision, compared to using Residual Income (RI)?

Answer options:

A.

The manager will accept the project under ROI, aligning with corporate goals.

B.

The manager will reject the project under ROI, causing goal congruence issues, whereas RI would encourage acceptance.

C.

The manager will accept the project under both ROI and RI.

D.

The manager will reject the project under both ROI and RI.

How to approach this question

Compare the project return (15%) to the current ROI (18%) to see the manager's view. Then compare the project return (15%) to the cost of capital (12%) to see the company's view (RI).

Full Answer

B.The manager will reject the project under ROI, causing goal congruence issues, whereas RI would encourage acceptance.✓ Correct
Under ROI, the manager will reject the 15% project because it is lower than their current 18% ROI, and accepting it would lower their divisional average. However, the company wants the project because 15% is greater than the 12% cost of capital. Residual Income (RI) solves this: the project generates positive RI (15% - 12% = 3% spread), so a manager evaluated on RI would accept it, achieving goal congruence.

Common mistakes

Assuming managers will accept any project above the cost of capital when evaluated on ROI.
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