Some companies use minimum rate of return and residual income to judge an investment center's performance and help managers make better decisions than if they rely solely on return on investment calculations.
When a company calculates residual income, making and understanding those calculations can often lead to better decision-making than simply relying on ROI calculations. This is because companies can change the minimum required rate of return as needed for evaluation, based on broad factors and expectations that are beyond the control of the investment center manager to influence. The minimum required rate of return is a pricing model that values an investment center based on achieving a minimum gain over a set period of time. This gives the manager of an investment center a target from which to be judged. If an investment center is not producing at the minimum target of return rate, then the business may conclude that it would be better to invest elsewhere so that minimum rate of return could be achieved.
Companies consider several factors in determining what the minimum required rate of return should be. These factors may include the level of risk of the investment center division's business, borrowing rates for the cost of acquiring capital, shareholder expectations, the overall state of the national and global economies, and the rate of return that other investment centers within the company are currently producing. Because these are all factors that can change independently of one another yet remain out of control of the investment center managers, companies can create a minimum required rate of return with these considerations in mind and then adjust it as conditions warrant.
Factors in Deciding a Minimum Required Rate of Return
For example, if a company has a minimum required rate of return of 4%, it means that the company believes it can earn 4% at a minimum on its capital assets if it invested those assets in alternative options. Therefore, the company would expect any capital commitment to an investment center to beat this rate of return. Otherwise, the company would be better off putting its money into the alternate option rather than into the investment center. Changing the minimum required rate of return allows companies to narrowly tailor expectations to meet the current situation and provides a more comprehensive method of evaluating investment center managers.
Minimum rate of return is one way to judge the performance of an investment center within an organization, but another option is to analyze residual income. Residual income is net operating income that an investment center generates above the minimum required return on its operating assets. Companies use a formula to calculate residual income.
Stated another way, residual income is operating income minus a level of minimum acceptable income given the operating assets employed. Residual income allows for the consideration of the net operating income that an investment center generates above the minimum required return on its operating assets. Net operating income is the amount of profit left after deducting all expenses but before accounting for interest and taxes.
Unlike an ROI calculation, which measures an investment center's return in relation to the amount of assets placed with that investment center, residual income also allows for consideration of an investment center's return in relation to a specified minimum required rate of return. For example, an investment center generates $100,000 in sales against $80,000 in costs. This results in an ROI of 25% which is calculated by dividing the $20,000 in profits against the $80,000 in costs. A company may then conclude that it should only put additional resources into this investment center if it will produce an ROI that is equal to or higher than the 25% that it currently produces. However, if the company achieves this return with $80,000 of operating assets against a minimum required rate of return of 10%, then the residual income is $12,000.
A company could have an opportunity to expand this investment center by increasing its amount of operating assets by $20,000. However, the return for increased sales could lead to a lower ROI. For example, with the new capital, the investment center might generate $123,000 in sales against $100,000 in costs. When calculated by dividing the $23,000 in profits against $100,000 in costs, this leads to an ROI that is now only 23%. However, the company is achieving this return with $100,000 of operating assets against the same minimum required rate of return of 10%; the residual income is $13,000.
In this case, the ROI is lower. It dropped from 25% to 23%. However, the residual income of $13,000 is higher than the previous residual income of $12,000. Thus, the company should commit these new assets to the investment center. Even though the ROI is lower, it still generates more of a positive return than what the company has already concluded it could earn putting that money elsewhere.
Calculating residual income can help managers demonstrate how profitable each investment center within an organization is. If companies simply relied on ROI to measure their investment centers, logic would suggest that whatever investment center is generating the highest ROI should be expanded and every other investment center shut down, even if they are profitable. Total reliance on ROI can mislead owners and managers because ROI does not take into account how a company balances the needs of its customers, employees, and vendors. It also focuses on short-term results and does not take into account how sustainable the success of a product line is. For instance, it does not measure how easily a rival can imitate or improve on a profitable product. And for many companies, brand reputation is important. If a company achieves high ROI because it begins using inferior raw materials, then that company may not survive.
For example, Northern Isles Widgets Incorporated has a widget-making investment center with average operating assets of $50,000. That center currently generates a net operating income of $10,000 with a minimum required return of 15%, which currently equals $7,500. The company wants to expand and create a new type of widget that would require additional operating assets of $12,500 to yield an additional net operating income of $2,250. However, the investment center manager who is evaluated on ROI would be reluctant to complete the new project. That is because it would send the manager's ROI below its current level. Nevertheless, completing the project would produce an ROI that is still above the minimum required return. It would also generate more income for the company overall when evaluated using a residual income standard. For these reasons, the company should expand into the new widget area, even though the ROI of the widget-making division would be reduced.