Return on investment (ROI) and Residual Income (RI)

Return on investment (ROI)

The learning outcome statements relevant for this section are:

1. define and calculate ROI
2. analyze and interpret ROI calculations
3. compare the benefits and limitations of ROI as measures of performance and explain their appropriate usage

What is return on investment (ROI)

Definitions

Return on investment (ROI)

A performance measurement tool that evaluates the profitability of an investment or division by comparing its operating income to the resources invested.

ROI provides a percentage measure of how efficiently a division or project generates returns relative to its assets or investment base, making it a key metric for assessing performance and guiding resource allocation.

$$\text{ROI}=\frac{\text{Operating income}}{\text{Average investment}}\times 100$$

Where:

• $\text{Operating income}$ represents the operating profit generated by the segment.
• $\text{Average investment}$ typically refers to the average book value of assets used during the period.

Suppose a division generates $200,000 in operating income and uses $1,000,000 in average assets. The ROI calculation would be:

$$\begin{array}{rl}\text{ROI}& =\text{(Operating income / average investment) × 100}\\ & =(200,000/1,000,000)\times 100\\ & =20\%\end{array}$$

This indicates that the division earns a return of 20% on its investment base.

Analysis and interpretation of ROI

ROI is a powerful tool for comparing the efficiency of different divisions or investments. A higher ROI indicates better performance, but it is important to interpret ROI in the context of the organization’s strategic goals and operational circumstances.

1. Profitability and efficiency: A high ROI suggests efficient use of assets to generate income, while a low ROI may indicate inefficiencies or underperformance. For example, divisions with outdated equipment might show lower ROI due to higher maintenance costs or reduced productivity.
2. Comparative analysis: ROI enables comparisons across divisions, projects, or investment opportunities. However, differences in asset intensity or operational scope can skew comparisons, making it important to adjust for these factors.
3. Goal alignment: ROI should align with the organization’s strategic goals. For instance, a division with a slightly lower ROI but significant growth potential may still be strategically valuable compared to a division with a higher ROI but limited future prospects.

ROI can also be broken into two drivers that explain what’s behind a given percentage: profit margin (how much profit the division keeps per dollar of sales) and asset turnover (how much sales the division generates per dollar invested).

$$\text{ROI}=\frac{\text{Operating income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Average investment}}=\text{profit margin}\times \text{asset turnover}$$

Going back to the division above: if its $200,000 in operating income came from $800,000 in sales, its profit margin is 25% ($200,000 ÷ $800,000) and its asset turnover is 0.8 ($800,000 ÷ $1,000,000). Multiplying $25\%\times 0.8=20\%$ reproduces the same ROI calculated earlier. This breakdown shows that a division can raise its ROI by improving its margin, generating more sales from the same assets, or shrinking its investment base.

Benefits and limitations of ROI

ROI offers key benefits that make it a widely used performance metric. Its simplicity and percentage format allow for quick calculations and easy comparisons across divisions or projects. ROI encourages efficient asset utilization by highlighting how well resources generate profits and provides a clear benchmark for evaluating investment opportunities. This makes ROI a practical tool for performance evaluation and decision-making.

While ROI is a versatile metric, it has its limitations. It does not account for risk, time value of money, or qualitative factors such as market conditions or competitive positioning. Additionally, ROI can incentivize short-term decisions if managers prioritize boosting ROI over long-term growth or innovation.

Residual income (RI)

The learning outcome statements relevant for this section are:

1. define and calculate residual income (RI)
2. analyze and interpret RI calculations
3. compare the benefits and limitations of RI as measures of performance and explain their appropriate usage

What is the residual income (RI)

Definitions

Residual income (RI)

A performance measurement tool that evaluates the operating income generated by a division or project after deducting a charge for the capital employed.

Unlike ROI, which measures profitability as a percentage, RI provides an absolute dollar figure, making it a useful metric for assessing whether a division generates income above the required return on investment.

$$\text{RI = operating income − (average investment × required rate of return)}$$

Where:

• $\text{Operating income}$ is the profit before interest and taxes.
• $\text{Average investment}$ refers to the division’s average assets or capital employed.
• $\text{Required rate of return}$ is the minimum acceptable return set by the organization, often based on the cost of capital.

Assume a division has $250,000 in operating income, uses $2,000,000 in average investment, and the required rate of return is 10%.

$$\begin{array}{rl}\text{RI}& =\text{Operating income − (average investment × required rate of return)}\\ & =250,000-(2,000,000\times 10\%)\\ & =250,000-200,000\\ & =\$50,000\end{array}$$

The residual income is $50,000, meaning the division has exceeded the required return by $50,000.

Analysis and interpretation of RI

RI is particularly useful for evaluating performance in organizations with decentralized operations. It encourages managers to focus on both profitability and efficient use of assets.

1. Excess profitability: A positive RI indicates that the division generates income above the required return, demonstrating effective use of capital. Conversely, a negative RI suggests that the division is not covering the cost of capital, indicating inefficiencies or underperformance.
2. Alignment with organizational goals: Unlike ROI, which may discourage managers from pursuing projects with lower returns than their division’s existing ROI, RI motivates managers to undertake investments that exceed the organization’s required rate of return, even if the division’s ROI decreases.
3. Flexibility in the capital charge: Because the required rate of return can differ by division, RI can charge a riskier division a higher rate than a low-risk one. As a dollar figure, though, RI tends to run larger for larger divisions, so it doesn’t by itself make it easy to rank divisions of different sizes - ROI is usually better suited for that kind of comparison.

The conflict between point 2 and ROI shows up directly in the numbers:

Example: ROI and RI can lead to different decisions

A division currently earns $200,000 in operating income on $1,000,000 in average investment, for an ROI of 20%. The company’s required rate of return is 10%, so the division’s current RI is $200,000 − ($1,000,000 × 10%) = $100,000.

The division manager is considering a new project that would add $30,000 in operating income on $200,000 in additional investment - a 15% return, which clears the 10% required rate.

• Effect on ROI: adding the project changes ROI to ($200,000 + $30,000) ÷ ($1,000,000 + $200,000) = $230,000 ÷ $1,200,000 ≈ 19.2%. Since 19.2% is below the division’s current 20% ROI, a manager evaluated on ROI would reject the project because it drags down the division’s overall ROI.
• Effect on RI: adding the project changes RI to $230,000 − ($1,200,000 × 10%) = $230,000 − $120,000 = $110,000. Since RI rises from $100,000 to $110,000, a manager evaluated on RI would accept the project.

Answer: The project returns 15%, above the 10% required rate, so accepting it benefits the company. RI leads the manager to accept it; ROI leads the manager to reject it.

Benefits and limitations of RI

RI’s main advantage is that it states performance in dollars, showing exactly how much value a division added above its required return, and it lets the organization set a different required rate for each division based on its risk.

Its main drawback is subjectivity: both the required rate of return and the valuation of the asset base involve judgment calls, which can make RI comparisons harder to defend than a straightforward percentage like ROI.

The investment base itself raises additional questions - for example, whether to use gross or net book value, and how shared assets or differing accounting policies affect comparability - which the next section, Investment base and calculation issues for ROI and RI, covers in detail.