(72)---THE ADVANTAGE AND WEAKNESSES OF RESIDUAL INCOME-COMPARED WITH RETURN ON INVESTMENT.

The advantage and weakness of Residual Income (RI) compared with Return on Investment (ROI).

The advantages of using Residual Income (RI) are as follows.

• Residual income will increase when investment earning above the cost of capital are undertaken and investments earning below the cost of capital are eliminated.
• Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics.

The weakness of RI is that it does not facilitate comparisons between investment centers nor does it relate the size of a centre’s income to the investment.

Residual Income (RI) versus Return on Investment (ROI): Marginally profitable investment.

Residual income (RI) will increase if a new investment is undertaken which earns a profit in excess of the imputed interest charge on the value of the asset acquired. Residual income (RI) will go up even if the investment only just exceeds the imputed interest charge, and this means that “marginally profitable” investment are likely to be undertaken by the investment centre manager.

Conclusion.

Residual income should not be used as a means of making asset purchasing decisions; nevertheless, it may be a useful alternative to ROI where there is a conflict between investment decisions indicated by a positive NPV in discounted cash flow, and the resulting reduction in divisional ROI which “reflects badly” on management performance.

Incompatible signals – Solutions to the problems.

As we have seen, ROI and RI do not always point to the right decision and so, whenever possible, a Discounted Cash Flow (DCF) approach to decision making should be adopted. Two possible refinements to the normal approach to calculating ROI and RI exist.
However, and these can be adopted if it is not possible to calculate an NPV or an IRR.