The ROI approach helps managers make decisions based on numbers that affect a department or division. 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.
Living in Houston, Gerald Hanks has been a writer since He has contributed to several special-interest national publications. Before starting his writing career, Gerald was a web programmer and database developer for 12 years. By Gerald Hanks. Discount Payback Period. Operating assets include productive assets plus intangible assets, and current assets.
One problem is determining which assets the manager can control with his or her decision-making authority. Deciding how to define invested capital is further complicated when combined with the additional decision of whether to use net book value depreciated value or gross book value nondepreciated value of long-lived assets. Net book value is the historical cost of an asset minus any accumulated depreciation, whereas gross book value is merely the historical cost of the asset.
Obviously at the time of acquisition of an asset, these two numbers are the same, but over time, net book value will decrease for any given asset, while gross book value will stay the same for that asset. Using gross book value will result in a higher value for invested capital than using net book value. Remember, net book value will vary based on the depreciation method employed—straight line versus double declining balance, for example.
Thus, gross book value removes the effect of choosing different depreciation methods. Despite this, most companies use net book value in the computation of ROI since net book value aligns with their financial reporting of capital assets on the balance sheet at their net value. Assets can also be measured at fair value, also known as market value. This is the value at which the assets could be sold.
The reason fair value is not typically used for ROI is that the fair or market value is rarely known or determinable with certainty and is often very subjective, whereas both gross and book value are readily known and determinable.
The second major component of these performance measures involves which income measure to use. First and foremost, no matter how a company measures income, the most important point is that the income the company uses as a measure should be controllable income if the performance model is to be a motivator and if the company uses responsibility accounting.
Income, sometimes referred to as earnings, can be measured in many ways, and there are often common acronyms given for some of the these measures. Common ways to measure income are operating income income before taxes ; earnings before interest and taxes EBIT ; earnings before interest, taxes, and depreciation EBITDA ; net income income after taxes ; or return on funds employed ROFE , which adds working capital to any of the other income measures.
Companies must decide which income measure they want to use in their determination of these various performance metrics. They must consider how the metric is being used, who they are evaluating by that metric, and whether the income and capital asset chosen capture the decision-making authority of the individual or division whose performance is being evaluated.
The manager of the SkyHigh division of Superball Corp. This ball bounces as high as a two-story building upon first bounce and is so popular that the SkyHigh division barely keeps up with demand. The manager is hoping the new machine will allow the balls to be produced more quickly and therefore increase the volume of production within the same time currently being used in production. The manager wants to evaluate the effect of the purchase of the machine on his compensation.
The information he has available for the analysis is shown here:. The manager is looking at several different measures to evaluate this decision. Answer the following questions:. Figure Dixon Construction Materials has collected this information:. Figure Which of the following measures the profitability of a division relative to the size of its investment in capital assets? What is the weighted average cost of capital for Ridley Enterprises?
Figure What is EVA and why is it superior to other performance measures? EVA is residual income adjusted for accounting distortions. Like residual income, it encourages managers to make appropriate levels of investment.
In addition, it treats items such as research and development costs as having a long-term benefit to the company. Figure What are the drawbacks to ROI? Give examples of each. Figure During the current year, Sokowski Manufacturing earned income of?
What is the sales margin? Figure Assume Skyler Industries has debt of? Figure During the current year, Plainfield Manufacturing earned income of? Using the sales margin from the previous exercise , what is the total ROI for the company during the current year?
Figure Assume Plainfield Manufacturing has debt of? During the most recent year, Macon had a net income of? Included in the income was interest expense of? Total assets were? What are the invested capital and ROI for Macon?
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FAQ Manuals Contacts. Sign up or. Investment center Before understanding the concept and working of residual income along with the examples, it is necessary that we understand the concept of an investment center. What is residual income? Economic value added EVA approach is an adaptation of the residual income. However, since it is a complex terminology and requires a better understanding of categorizing the expenses as the capital expense, this will be best understood after clearing the concepts related to residual income.
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