Kellard Group: Divisional ROI, Residual Income and a Rejected Project
Kellard Group has two divisions. Division A: operating profit $180,000, net assets $1,200,000. Division B: operating profit $96,000, net assets $600,000. The group's cost of capital is 12%. Division A's manager is considering a project requiring $300,000 of investment that would generate additional annual operating profit of $42,000. Divisional managers' bonuses are linked to divisional ROI, and both are computed on the same accounting policies, except that Division A's assets are old and heavily depreciated while Division B's plant was commissioned last year. The board is also worried about a sharp rise in customer complaints and staff turnover in Division B, which its management report does not mention.
1. Calculate ROI and residual income for both divisions, and the effect of the proposed project on Division A's ROI and RI. Predict the manager's decision under each measure.
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Current position
| A | B | |
|---|---|---|
| Operating profit | 180,000 | 96,000 |
| Net assets | 1,200,000 | 600,000 |
| ROI | 15.0% | 16.0% |
| Imputed charge (12%) | 144,000 | 72,000 |
| Residual income | 36,000 | 24,000 |
Project in Division A Operating profit 180,000 + 42,000 = 222,000; net assets 1,200,000 + 300,000 = 1,500,000
- ROI = 222,000 / 1,500,000 = 14.8% (down from 15.0%)
- RI = 222,000 − (12% × 1,500,000 = 180,000) = $42,000 (up from $36,000 by $6,000)
Prediction: the project earns 14% ($42,000 / $300,000), above the 12% cost of capital, so it should be accepted. But under an ROI-based bonus the manager's ROI falls from 15.0% to 14.8% and the bonus is at risk, so a rational manager rejects it. Under RI the bonus rises by $6,000 and the manager accepts. This is the classic sub-optimal-decision weakness of ROI.
2. Advise the board which measure to use for divisional performance and bonus purposes, and identify the distortions in the figures as presented.
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Recommendation: use residual income (or a variant such as EVA) for bonus purposes, because it is congruent with group objectives - any project above 12% increases RI, so managers invest whenever the group should. ROI creates an incentive to under-invest and even to dispose of assets that earn above the cost of capital but below the division's current average. ROI remains useful as a supplementary comparability ratio, but not as a bonus trigger.
Distortions that must be corrected before any comparison is made:
- Age of assets. Division A's assets are heavily depreciated, which lowers its net asset base and inflates its ROI; Division B's new plant carries high written-down value and depresses its ROI. Comparing 15% with 16% therefore tells you more about asset age than about managerial performance. Use gross book value, or current replacement cost, consistently - or compare RI, which is less sensitive but still affected.
- Size. A's RI of $36,000 exceeds B's $24,000 despite B's higher ROI - RI rewards absolute profit and disadvantages smaller divisions. A percentage-only view would rank B first and RI ranks A first. Neither is 'right'; the board should judge absolute contribution and also make an allowance for capital employed.
- Short-termism. Both measures are built on accounting profit; they can be improved by cutting discretionary spend (R&D, training, maintenance) that has no immediate profit effect. Consider a three-year rolling measure or a balanced scorecard overlay.
- Controllability. Only charge divisions with assets and costs they control, and separate group-allocated overheads.
3. Recommend non-financial performance measures for Division B, linking them to the balanced scorecard perspectives.
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The financial report is silent on the two symptoms the board has already identified, so measures are needed that make them visible:
Customer perspective
- Number of complaints per 1,000 orders and percentage resolved within 5 working days (the volume of complaints is rising - track both level and speed of resolution).
- On-time delivery percentage and order-to-delivery lead time.
- Customer retention rate / repeat order percentage (complaints may already be costing revenue not yet visible in profit).
Internal business process perspective
- Percentage of orders reworked or returned; first-time-right rate.
- Machine downtime and schedule adherence - a plausible driver of both complaints and staff stress.
- Number of unresolved quality incidents older than 30 days.
Learning and growth perspective
- Staff turnover, analysed between voluntary leavers in their first year and later; absence rate; overtime hours per employee.
- Training hours per employee and percentage of vacancies filled internally (rising turnover plus falling training is a classic deterioration signal).
Financial perspective
- Retain ROI and RI as context, plus revenue per employee and cost of quality as a percentage of sales.
Presentation advice: report these monthly alongside the financials with trend arrows and targets, and explicitly link them - e.g. if first-time-right falls, warranty cost and complaints should be expected to follow. Non-financial measures are leading indicators; the profit effect of today's complaints will appear next year, which is precisely why the current report has not shown them.