Compare and contrast the return on investment and residual income measures of divisional performance

Return on investment (ROI) is very similar to return on capital employed (ROCE) except the focus is on controllable and traceable revenues, expenses and assets. It measures the return on the investment in assets for a business or division. The following formula is used:

Residual income is another measure of performance based on the investment in assets. It compares the profit actually earned to the minimum level of profit required for the business. It is profit earned less interest or minimum return on the capital that has been employed to genera the profit. The residual income formula is:

 The following example illustrates their calculation

The Millenium Cinema Group opened a new division in Limerick . The investment in the Limerick division amounted to €5m and profit of €900,000 was generated in the first year of trading. The weighted average cost of capital for the group is 10 per cent.

The performance of the Limerick division can be measured using return on investment and residual income as follows:

Return on investment is a common measure in performance evaluation. Its main advantages are that it is a financial accounting measure that is understandable to managers and can be analysed into its component parts (asset turnover and operating profit margin and as it is a common measure it is ideal for comparison across corporate divisions for companies of similar size and in similar sectors.

On the other hand residual income is considered a better overall performance measure as it is an absolute measure. In other words it measure in terms of money rather than as a percentage. However the main drawbacks associated with using residual income is that it can be difficult to calculate the minimum required return or cost of capital for a business and ultimately the measure is not as well understood and known by managers as return on investment.

Outline three reasons why return on investment may be an unreliable measure of divisional performance

• The level of investment or capital employed can be difficult to measure and this can distort inter-firm comparisons. For example, comparing ROI for hotels that periodically revalue their property assets to those that don’t, can be misleading. The companies with the revalued properties will have a higher asset base and hence a lower return on investment. If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery.
• Different accounting policies will affect both profits and asset or investment values. Thus inter-firm comparisons can be very misleading if the companies involved do not have similar accounting policies with regard to fixed assets, stocks and certain intangible assets such as research and development.
• The use of ROI can lead to dysfunctional decisions made by managers as it is expressed as a percentage rather than as an absolute measure as in residual income.