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Understanding Profitability Measurement in Divisional Responsibility Accounting

This document explores the importance of measuring profitability within profit and investment centers, focusing on relative measures such as Return on Investment (ROI), Residual Income (RI), and Economic Value Added (EVA™). It highlights how ROI offers insights into performance comparison yet may lead to suboptimal managerial decisions. RI is discussed as a tool that fosters goal congruence among division managers by considering the cost of capital. Finally, EVA™ is elaborated as an enhanced measure that refines traditional profit calculations, incorporating necessary accounting adjustments for a current economic profit assessment.

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Understanding Profitability Measurement in Divisional Responsibility Accounting

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  1. LEARNING NOTE 14.1 Responsibility accounting in profit and investment centres

  2. LN14.1 (1) Measuring divisional profitability • Ideally focus should be on relative measures (profitability)rather than absolute measures of profit. • Alternative profitability measures: 1. Return on investment (ROI) 2. Residual income (RI) 3. Economic value added (EVA ™)

  3. LN14.1 (2a) Return on investment Division ADivision B Profit £1m £2m Investment £4m£20m ROI 25%10% • Division B earns higher profits but A is more profitable. • ROI is a relative measure of performance that can becompared with other investments. It also provides a usefulsummary measure of the ex post return on capitalemployed. • A major disadvantage of ROI is that managers may bemotivated to make decisions that make the company worseoff.

  4. LN14.1 (2b) Division X Division Y Investment project available £10 million £10 million Controllable contribution £2 million £1.3 million Return on the proposed project 20% 13% ROI of divisions at present 25% 9% The overall cost of capital for the company is 15% The manager of X would be motivated not to invest and the manager of Y would be motivated to invest.

  5. LN14.1 (3a) Residual income • Controllable residual income = Controllable profit less acost of capital charge on the investment controllable by themanager. • It is claimed that RI is more likely to encourage goalcongruence Division X (£m) Division Y (£m) Proposed investment 10 10 Controllable profit 2 1.3 Cost of capital charge (15%) 1.5 1.5 Residual income +0.5 – 0.2

  6. LN14.1 (3b) • The manager of division X is motivated to invest and themanager of division Y is motivated not to invest. • If RI is used it should be compared with budgeted/target levels which reflect the size of the divisional investment. • Empirical evidence indicates that RI is not widely used.

  7. LN14.1 (4) Economic value added (EVA™) • During the 1990s RI was refined and renamed EVA ™. • EVA ™ = Conventional divisional profit based on GAAP ± Accounting adjustments – Cost of capital charge on divisional assets • Conventional divisional profit based on principles outlined formeasuring divisional managerial and/or economic profits. • Adjustments intended to convert historic accounting profit to anapproximation of economic profit. • Adjustments typically include capitalization of discretionary expenses.

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