return on investment and residual income
/ ROI = 'arr-oh-eye'; RI = 'arr-eye' /
Two friends each ran a small business last year. One earned 20,000 of profit, the other 50,000. Who did better? You can't say until you ask how much each had to put in. If the first invested 100,000 and the second 500,000, the first earned 20 cents per dollar invested and the second only 10 — so 'less profit' was actually the better use of money. Return on investment and residual income are the two standard tools for judging an investment center fairly by comparing its profit to the resources it used.
Return on investment (ROI) is a ratio: operating income divided by the average operating assets used to earn it, usually shown as a percent. If a division earns 80,000 of operating income on 400,000 of assets, its ROI is 80,000 / 400,000 = 20 percent. Residual income (RI) instead gives a dollar figure: operating income minus a 'capital charge' equal to a required minimum rate of return times the assets. With a 12 percent required return, the same division's RI is 80,000 − (12 percent × 400,000) = 80,000 − 48,000 = 32,000 — the profit left over after covering the cost of the capital invested. ROI tells you the percentage; RI tells you the surplus dollars above a hurdle.
Both matter for evaluating divisions and for deciding where to put money, but they have a famous tension. ROI can mislead managers into rejecting good projects: a division already earning 20 percent ROI might turn down a project returning 16 percent because it would drag the division's average down — even though 16 percent beats the company's 12 percent required return and would create value. Residual income fixes this, because any project earning above the 12 percent hurdle raises RI and so is accepted. The caveats: both rely on accounting profit and asset values that can be distorted (old, depreciated assets flatter ROI), and chasing either number can tempt managers toward short-term moves over long-term health.
A division earns 20 percent ROI on 400,000 of assets (80,000 profit). A new project would add 30,000 of profit on 200,000 of assets — a 15 percent return. Adding it lowers the division's ROI to (80,000 + 30,000) / 600,000 = 18.3 percent, so an ROI-driven manager rejects it. But with a 12 percent company hurdle, the project's RI is 30,000 − (12 percent × 200,000) = 6,000 positive, so an RI-driven manager correctly accepts it.
ROI can reject value-creating projects that RI correctly accepts.
ROI's percentage view can push a high-ROI division to reject projects that still beat the company's required return; residual income avoids that trap. But both rest on accounting figures, and old depreciated assets can flatter ROI artificially.