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Divisional performance measurement and transfer pricing

1.4 The Residual Income (RI)
$

Controllable operating profit X
Less: Imputed interest (controllable capital employed × cost of capital) (X)

–––
RI X

–––

Decision rule: accept project or assess the division as performing favourably if RI is
positive.

1.5 RI evaluation

Advantages Disadvantages

 Reduces problems of ROI,  Can still result in dysfunctional
i.e. dysfunctional behaviour and behaviour (EVA is a superior
holding onto old assets measure)

 Easy decision rule  Absolute figure so does not facilitate
comparisons
 Makes divisional managers more
aware of cost of finance  Difficult to determine appropriate
cost of capital
 Different cost of capitals can be
applied to divisions with different  Different accounting policies can
risk profiles confuse comparison

 May encourage manipulation of
profit or capital employed figures

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