ROI vs Residual Income: Measuring Divisional Performance
Why a good project can look bad on ROI, and how residual income fixes it.
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Residual income = Profit − (Required return × Capital employed)
Worked example: two divisions
The company requires a return of 12% on capital employed.
| Division A | Division B | |
|---|---|---|
| Profit | 60,000 | 33,000 |
| Capital employed | 400,000 | 200,000 |
| ROI | 60,000 ÷ 400,000 = 15.0% | 33,000 ÷ 200,000 = 16.5% |
| Capital charge (12%) | 48,000 | 24,000 |
| Residual income | 60,000 − 48,000 = 12,000 | 33,000 − 24,000 = 9,000 |
Division B has the higher ROI (16.5% vs 15%), but Division A adds more value in absolute terms (RI of 12,000 vs 9,000), because it uses more capital at a return above 12%. The two measures can rank divisions differently.
The project test: a good project, a lower ROI
Each division can invest 50,000 in a project that earns 7,000 a year, a return of 14%. That is above the required 12%, so it is a good investment for the company.
| Division A | Division B | |
|---|---|---|
| ROI before | 15.0% | 16.5% |
| ROI after (A: 67,000 ÷ 450,000; B: 40,000 ÷ 250,000) | 14.9% | 16.0% |
| RI before | 12,000 | 9,000 |
| RI after (A: 67,000 − 54,000; B: 40,000 − 30,000) | 13,000 | 10,000 |
| Change in RI | +1,000 | +1,000 |
The project lowers each division’s ROI, because its 14% return is below the divisions’ existing 15% and 16.5%. A manager judged on ROI might reject it. But it raises residual income by 1,000 in each case: 7,000 earned less a capital charge of 6,000 (12% × 50,000). The company would be better off if the project goes ahead.
Strengths and limitations
| Measure | Strengths | Limitations |
|---|---|---|
| ROI | Easy to understand; a percentage that compares divisions of different sizes | Can lead managers to reject projects that earn above the cost of capital but below their current ROI |
| Residual income | Encourages any project earning more than the required return; considers the cost of capital | An absolute amount, so it favours larger divisions; needs an agreed required return |
Both measures depend on how profit and capital employed are defined, and on the age and depreciation of assets. Both focus on financial results, so many businesses add non-financial measures to a balanced view of performance.
Common mistakes
- Forgetting the capital charge when calculating residual income.
- Comparing ROI of divisions without thinking about different asset ages and risk.
- Judging a project by its effect on ROI alone. Compare the project’s own return with the required return.
Quick check
1. A division earns 45,000 on capital of 300,000, and the required return is 10%. What are its ROI and residual income?
ROI = 45,000 ÷ 300,000 = 15%. Residual income = 45,000 − (10% × 300,000) = 45,000 − 30,000 = 15,000.
2. Why might a manager rejecting a project earning 11% be right if the required return is 12%?
Because the project earns less than the required return, so it would reduce residual income and not add value for the company.
Practise with Problem 7 (ROI vs residual income).
Frequently asked questions
What is residual income?
Profit minus a charge for the capital used, calculated as the required return multiplied by capital employed. A positive figure means the division earns more than the required return.
Why can ROI discourage good investments?
A project that earns more than the cost of capital but less than the division’s current ROI lowers the divisional average, so a manager measured on ROI may turn it down.
Which is better, ROI or residual income?
Neither is perfect. ROI is a convenient percentage, while residual income better aligns managers’ decisions with company value. Many firms use both.
Keep learning
- Management Accounting learning path
- Return on investment (glossary)
- Investment appraisal
- Management problems
This lesson is for general learning. Terminology and layouts vary by syllabus and country.
