Advantages and disadvantages of residual Income

Residual Income
In an effort to overcome the tendency to use ROI to turn down investments that are profitable for the company but that lower a division’s ROI, some companies hav adopted an alternative performance measure known as residual income. Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Residual income = Operating income- (Minimum rate of return x Operating assets)

Advantages of Residual Income
To illustrate the use of residual income, consider the Cleaning Products Division example again. Recall that the division manager rejected Project I because it would have reduced divisional ROI, which cost the company $300,000 in profits. The use of residual income as the performance measure would have prevented this loss. The residual income for each project is computed below.

Notice that both projects increase residual income; in fact, Project I increases divisional residual income more than Project II does. Thus, both would be selected by the divisional manager. For comparative purposes, the divisional residual income for each of the four alternatives identified earlier follows:

Disadvantages of Residual Income
Two disadvantages of residual income are that it is an absolute measure of return and that it does not discourage myopic behavior. Absolute measures of return make it difficult to directly compare the performance of divisions. For example, consider the residual income computations for Division A and Division B, where the minimum required rate of return is 8 percent.

As indicated, selecting both projects produces the greatest increase in residual income. Adding both projects is now the preferred alternative. With this new measure employed, managers are encouraged to accept any project that earns above the minimum rate.

At first glance, it is tempting to claim that Division A is outperforming Division B, since its residual income is three times higher. Notice, however, that Division A used six times as many assets to produce this difference. If anything, Division B is more efficient. One possible way to correct this disadvantage is to compute a residual return on investment by dividing residual income by average operating assets. This measure indicates that Division B earned 4 percent while Division A earned only 2 percent. Another possibility is to compute both return on investment and residual income and use both measures for performance evaluation. ROI could then be used for interdivisional comparisons.

The second disadvantage of residual income is that it, like ROI, can encourage a short-run orientation. Just as a manager can choose to cut maintenance, training, and sales force expenses when being evaluated under ROI, the manager being evaluated on the basis of residual income can take the same actions. The problem of myopic behavior is not solved by switching to this measure.

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