Residual Income (RI)

Residual income is a measure used as part of divisional performance management for investment centres.

Evaluation of RI as a performance measure

Compared to using return on investment (ROI) as a measure of performance, RI has several advantages and disadvantages:

Advantages

• It encourages investment centre managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole.
• Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control.

Disadvantages

• It does not facilitate comparisons between divisions since the RI is driven by the size of divisions and of their investments.
• It is based on accounting measures of profit and capital employed which may be subject to manipulation, e.g. in order to obtain a bonus payment.

Comparing divisional performance

Divisional performance can be compared in many ways. ROI and RI are common methods but other methods could be used.

• Variance analysis is a standard means of monitoring and controlling performance. Care must be taken in identifying the controllability of, and responsibility for, each variance.
• Ratio analysis - there are several profitability and liquidity measures that can be applied to divisional performance reports.
• Other management ratios - this could include measures such as sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour.
• Other information such as staff turnover, market share, new customers gained, innovative products or services developed.

Further topics

The most common alternative to RI is to use return on investment (ROI) instead.

One way of trying to solve the problem of dysfunctional decision making, especially with ageing assets is to use annuity depreciation.

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags:	residual income;RI;Divisional Performance;divisional performance management