Return on investments is a financial ratio that measures the rate of return of a company's investments. Companies use ROI to compare the efficiency of a number of investments. Residual income is another approach to measuring the performance of an investment. It is the net operating income an investment earns above the minimum required return on its operating assets.
To calculate ROI, investors add the gain from the investment to the cost of the investment. Then they divide this number by the cost of the investment. The cost of the investment is also called average operating assets or the amount invested. To calculate residual income, investors first divide operating income by the average operating assets (the investment amount). The last step is to subtract this number from operating income to arrive at the residual income. The end results of the two calculations are a little different. ROI is expressed as a percentage of the amount of capital invested. Residual income is expressed as an amount in dollars the investment made above the ROI.
Types of Information Provided
Companies that have policies of evaluating investments based on ROI have begun to switch to the residual income method. The main reason for this is that the residual income method provides more information. Managers look at ROI and make decisions based upon whether the investment meets minimum requirements based upon their yield. It doesn't take into consideration how much money the investment made in addition to the minimum yield. When companies use the residual income method, management is evaluated based on the growth in the residual income from year to year instead of the growth in the rate of return.
One of the main reasons why companies are switching from the ROI to the residual income method has to do with how managers choose new investments. Since the two methods measure investment profitability differently, they have different end results. Using the residual income approach helps managers make investments that are profitable for the entire company. The ROI approach helps managers make decisions based on numbers that affect a department or division.
Evaluating Managerial Decisions
In most cases, a manager who uses the ROI method will reject any project whose rate of return is below the division's current ROI. It doesn't matter if the rate of return on the investment is above the minimum rate of return for the entire company. The residual income method offers more opportunities. Projects whose rate of return is above the minimum required rate of return of the company will increase residual income. It is more profitable for companies to accept projects that offer returns higher than the minimum rates of return. Managers who are evaluated based on the residual income method will make better decisions about investments than managers who are evaluated based on the ROI method.