Divisional performance analysis

In this lesson

1. 0:00 Divisional performance analysis overview
2. 1:12 Return on investment calculation and application
3. 2:29 ROI advantages and disadvantages
4. 3:40 Residual income concept and interpretation
5. 5:24 Residual income advantages and disadvantages
6. 6:12 Worked example: ROI with asset adjustments

About this lesson

These techniques are essential for assessing investment centres in performance management and are frequently tested in PM, APM, and SBL papers. Return on investment measures profit generated relative to capital employed, expressed as a percentage. It's particularly useful because it allows you to compare divisions of different sizes fairly—a smaller division with higher ROI may outperform a larger one with lower ROI. However, ROI can encourage dysfunctional decision-making: managers may reject profitable projects that would dilute their current ROI, even if those projects meet the company's target return. Additionally, older assets inflate ROI figures, potentially tempting managers to manipulate reported profits and capital values. Residual income addresses many ROI limitations by measuring profit after deducting a notional interest charge based on the company's cost of capital. A positive residual income signals that a division has exceeded the return expected by its capital providers, while negative residual income indicates underperformance. Unlike ROI, residual income provides a clear decision rule: accept any project offering a return above the cost of capital. The trade-off is that residual income produces an absolute figure, making it harder to compare divisions of vastly different sizes, and determining the correct cost of capital can be challenging. The video walks through practical calculations and adjustments, including how to correct year-end figures when assets are bought or sold and how these changes affect both metrics. Understanding both approaches equips you to choose the right measure for different contexts and to recognise the behavioural implications of each.

Duration: 9m