business in the long term – such as cutting back on staff training or research expenditure. Using ROI as a performance measure for a divisional manager may lead to ‘goal incongruence’, where a manager rejects a potential project that may generate a positive net present value, if the project would reduce the manager’s measured return on investment. ROI is that it by itself says nothing about the likelihood that expected returns and costs will appear as predicted. Neither does it say anything about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the expected results. Therefore, a good investment analysis should also measure the probabilities of different ROI outcomes. It is important to consider both the ROI magnitude and the risks that go with it.
Residual Income RI
Residual Income The weaknesses of the ROI method, particularly the fact that it ignores the cost of financing a division, has led some businesses to search for a more appropriate measure of divisional performance. An alternative measure is that of residual income (RI). RI is the amount of income, or profit, generated by a division, which is in excess of the minimum acceptable level of income. If we assume that the objective of the business is to increase owners’ (shareholders’) wealth, the minimum acceptable level of income to be generated is the amount necessary to cover the cost of capital. Taking the divisional profit figure and then deducting an imputed charge for the capital invested gives the RI.
Residual Income Instead of using a percentage measure, as with ROI, the Residual Income approach assesses the manager on absolute profit. However, in order to take account of the capital investment, notional (or imputed, or ‘pretend’) interest is deducted from the P&L profit figure. The balance remaining is known as the Residual Income. Residual income (RI) = divisional profit less a capital charge (investment × cost of capital). In practice, ROI is more popular than RI, despite the fact that RI is technically superior.
Residual Income- Decision Rule A positive RI means that the division is generating returns in excess of the minimum requirements of the business. The higher these excess returns, the better the performance of the division. A negative RI means that the division is generating returns far below the minimum requirements of the business. The lower these returns, the worse the performance of the division. A zero RI means that the division is generating returns just equal to the minimum requirements of the business. This state of affairs could neither be assessed as the better than nor worse than performance of the division.
Advantages It encourages investment centre managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole.