Very often, Return On Capital Employed (ROCE) or also known as Return On Investment (ROI) is used in many divisional performance evaluation as ROCE measures the relationship between a division’s profit and the amount of the group has invested in the division.

At a quick glance profit percentage of capital employed, profit % of sales and sales to capital employed are linked to form the pyramid of ratios or simply in terms of formula = profit/sales x sales/capital employed = ROCE.

However, some do not favor using this return on capital employed ratio as divisional performance measure as they believe that it is possible for unscrupulous divisional managers to achieve a high short-term ROCE by manipulating their division’s capital employd and profit figures.

Let’s look at some of the way, a divisional manager can manipulate ROCE to his or her advantage:

• reject new investments which may earn a lower percentage(%) return than the current ROCE even if they earn more than the percentage(%) cost of capital;
• dispose of assets which achieve less than the ROCE even if their percentage(%) return exceeds the cost of the capital tied up in them;
• retain fully depreciated assets rather than replace them with more productive assets;
• reject investments which may take several years to achieve full profitability;
• delay maintenance expenditure to the next financial year.

The aforesaid actions will disadvantage overall group’s goal.Hence, they are examples of “dysfunctional behavior”

Advocates of Residual Income believe that this method is superior to ROCE as a divisional performance measure.

Let’s understand what’s really is Residual Income(RI):

Residual income is NOT A RATIO-it is the absolute profit that a division makes in a period LESS an interest charge for the NOTIONAL cost of the capital employed by the division. So the greater the capital employed, the greater the interest charged

Residual Income method is believed to lead to better goal congruence than if ROCE as it provide an incentive to invest in or retain any assets which will achieve a higher percentage(%) return than the interest charge.

Residual Income can be used to compare the performance of a division from one year to the next. Compared to the easier way using ROCE,comparison based on residual income can be difficult unless divisons are similar to size and the same interest rate is charged on their capital employed.

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