Residual Income-A Method to Measure Managerial Performance:

Definition and explanation of residual income method:

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets.

residual income vs roi is another approach to measuring an investment center’s performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses. under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA.

When residual income or EVA is used to measure managerial performance, the objective is to maximize the total amount of residual income or EVA, not to maximize return on investment (ROI).

Example:

For the purpose of illustrating consider the following data for an investment center of a company.

 Basic Data for Performance Evaluation Average operating assets Net operating income Minimum required rate of return \$100,000 \$20,000 15%

The company has long had a policy of of evaluating investment center managers based on ROI, but it is considering a switch to residual income. The controller of the company, who is in favor of the change to residual income, has provided the following table that shows how the the performance of the division would be evaluated under each of the two methods:

 Alternative Performance Measures ROI Residual income Average operating assets (a)Net operating income (b) ROI, (b) ÷ (a) Minimum required return (15%  \$100,000)Residual income \$100,000 ======= \$20,000 20% \$100,000 ======= \$20,000 15,000 ———- \$5,000 =======

The reasoning underlying the residual income calculation is straight forward. The company is able to earn a rate of return of at 15% on its investments. Since the company has invested \$100,000 in the division in the form of operating assets, The company should be able to earn at least \$15,000 (15% × \$100,000) on this investment. Since the division’s net operating income is \$20,000, the residual income above and beyond the minimum required return is \$5,000. If residual income is adopted as the performance measure to replace ROI, the manager of the division would be evaluated based on the growth in residual income from year to year.

Comparison of return on investment (ROI) and residual income:

One of the primary reasons why controllers of companies would like to switch from ROI to residual income has to do with how managers view new investment under the two performance measurement schemes. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated by ROI formula.

To illustrate consider the data mentioned above and further suppose that the manager of the division is considering purchasing a machine. The machine would cost \$25,000 and is expected to generate additional operating income of \$4,500 a year. From the stand point of the company, this would be a good investment since it promises a rate of return of 18% [(\$4,500 / \$25,000) ×100], which is in excess of the company’s minimum required rate of return of 15%. If the manager of the division is evaluated based on residual income, she would be in favor of the investment in the machine as shown below.

 Performance evaluated using residual income Present New Project Overall Average operating assetsNet operating income Minimum required returnResidual income \$100,000 ======= \$20,000 15,000 ———– \$5,000 ======== \$25,000 ======= \$4,500 3,750 ———– \$750 ======== \$125,000 ======== \$24,500 18750 ———– \$5,750 =======

Since the project would increase the residual income of the division, the manager would want to invest in the new machine.

Now suppose that the manager of the division is evaluated based on the return on investment (ROI) method. The effect of the machine on the division’s ROI is computed as below:

 Performance evaluated using residual income Present New project Overall Average operating assets (a) Net operating income (b) ROI, (b) ÷ (a) \$100,000 \$20,000 20% \$25,000 \$4,500 18% \$125,000 \$24,500 19.6%

The new project reduces the ROI from 20% to 19.6%. This happens because the 18% rate of return on the new machine, while above the company’s15% minimum rate of return, is below the division’s present ROI of 20%. Therefore the new machine would drag the division’s ROI down even though it would be a good investment from the standpoint of the company as a whole. If the manager of the division is evaluated based on ROI, she would be reluctant to even propose such an investment.

Basically, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division’s current ROI even if the rate of return on the project is above the minimum rate of return for the entire company. In contrast, any project whose rate of return is above the minimum required rate of return of the company will result in an increase in residual income. Since it is in the best interest of the company as a whole to accept any project whose rate of return is above the minimum rate of return, managers who are evaluated on residual income will tend to make better decisions concerning investment projects than manager who are evaluated based on ROI.