Residual income and how it overcomes a limitation of ROI

Return on investment and its limitation

Return on investment (ROI) measures the performance of an investment centre (a division) as a percentage:

ROI = Divisional operating profit ÷ Investment (capital employed) × 100.

ROI is easy to understand and compare, but it has an important limitation. A divisional manager judged on ROI may reject a project that would benefit the company because it lowers the division's present ROI, even though the project's return is above the company's cost of capital. Equally, a manager may keep or accept investments with low returns if they raise a weak division's ROI. ROI therefore can lead to decisions that are not in the interest of the company as a whole (lack of goal congruence).

Example: a division earns ROI of 25 per cent. A new project needing ₹10,00,000 promises 18 per cent. The company's cost of capital is 15 per cent. The project is good for the company (18 > 15), but accepting it would reduce the division's ROI, so a manager judged on ROI may reject it.

Meaning of residual income

Residual income (RI) is the operating profit of a division minus a charge for the capital it uses, at the company's required rate of return (cost of capital):

RI = Divisional operating profit − (Investment × Required rate of return).

It shows the profit earned over and above the minimum return expected on the capital employed.

How residual income overcomes the limitation

1. Goal congruence. Any project earning more than the required rate adds to RI. In the example, the project earns ₹1,80,000 against a capital charge of ₹1,50,000, so RI rises by ₹30,000 and the manager will accept it: the same decision that is best for the company.
2. Absolute measure. RI is in rupees, so it rewards growth in profit above the cost of capital, not just a high percentage on a small base.
3. Different risk rates. Different required rates can be applied to divisions or assets of different risk.
4. Discourages excess assets. Every rupee of investment carries a charge, so managers have a reason to release idle assets.

Limitations of residual income

1. It is an absolute figure, so it favours large divisions and is hard to use for comparing divisions of different size.
2. It depends on choosing the right required rate of return.
3. It still uses accounting profit and book values of assets, so depreciation and asset valuation affect it.

Conclusion

Residual income removes ROI's main weakness by charging each division for its capital at the company's cost of capital, so that managers accept every investment that earns more than that cost. Many firms use both measures together.