ROI and residual income

In this lesson

1. 0:00 Return on Investment explained
2. 1:03 ROI formula and controllable profit
3. 1:07 Investment decision criteria with ROI
4. 2:01 ROI advantages and disadvantages
5. 4:23 Dysfunctional behaviour example with ROI
6. 6:23 Residual Income fundamentals
7. 8:27 Residual Income investment decisions
8. 9:24 Comparing ROI and Residual Income
9. 11:18 Residual Income advantages and disadvantages

About this lesson

This lesson covers the formulas, advantages and disadvantages of each approach, and real examples of dysfunctional decision-making that can arise when using ROI alone. Understanding both measures and their trade-offs is essential for Performance Management and will help you evaluate divisional performance effectively in your exam. ROI (return on investment) measures divisional profit against capital employed, making managers accountable for both profitability and asset use. The formula is controllable profit divided by divisional capital employed. While ROI is easy to calculate and allows comparison across divisions of different sizes, it can encourage short-termism and underinvestment—managers may reject profitable projects if they fall below their current ROI, even if they exceed the company's cost of capital. This creates dysfunctional behaviour where individual managers prioritise their own performance metrics over corporate benefit. Residual income takes a different approach: divisional profit minus an imputed interest charge (usually the company's weighted average cost of capital applied to net assets). This method encourages investment because managers simply ask whether profit exceeds the finance cost of capital. Positive residual income is good; negative is rejected. Residual income aligns better with discounted cash flow analysis and reduces dysfunctional decision-making, but it's harder to understand, more complex to calculate, and makes divisional comparison difficult since it's expressed as an absolute figure rather than a percentage. The key takeaway: neither measure is perfect. ROI favours simplicity but risks short-term thinking; residual income encourages better investment decisions but demands more sophistication. In exam answers, be ready to discuss both strengths and limitations, and explain how combining multiple performance measures helps balance these trade-offs.

Duration: 13m