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.
Return on investment [ROI] is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
To calculate ROI, the benefit [or return] of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
Key Takeaways
- Return on Investment [ROI] is a popular profitability metric used to evaluate how well an investment has performed.
- ROI is expressed as a percentage and is calculated by dividing an investment's net profit [or loss] by its initial cost or outlay.
- ROI can be used to make apples-to-apples comparisons and rank investments in different projects or assets.
- ROI does not take into account the holding period or passage of time, and so it can miss opportunity costs of investing elsewhere.
- Whether or not something delivers a good ROI should be compared relative to other available opportunities.
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How To Calculate Return On Investment [ROI]
How to Calculate Return on Investment [ROI]
The return on investment [ROI] formula is as follows:
ROI=Current Value of Investment−Cost of InvestmentCost of Investment\begin{aligned} &\text{ROI} = \dfrac{\text{Current Value of Investment}-\text{Cost of Investment}}{\text{Cost of Investment}}\\ \end{aligned}ROI=Cost of InvestmentCurrent Value of Investment−Cost of Investment
"Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
Understanding ROI
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects on expanding a factory, or the ROI generated in a real estate transaction.
The calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options. Likewise, investors should avoid negative ROIs, which imply a net loss.
For example, suppose Jo invested $1,000 in Slice Pizza Corp. in 2017 and sold the shares for a total of $1,200 one year later. To calculate the return on this investment, divide the net profits [$1,200 - $1,000 = $200] by the investment cost [$1,000], for an ROI of $200/$1,000, or 20%.
With this information, one could compare the investment in Slice Pizza with any other projects. Suppose Jo also invested $2,000 in Big-Sale Stores Inc. in 2014 and sold the shares for a total of $2,800 in 2017. The ROI on Jo’s holdings in Big-Sale would be $800/$2,000, or 40%.
Limitations of ROI
Examples like Jo's [above] reveal some limitations of using ROI, particularly when comparing investments. While the ROI of Jo's second investment was twice that of the first investment, the time between Jo’s purchase and the sale was one year for the first investment but three years for the second.
Jo could adjust the ROI of the multi-year investment accordingly. Since the total ROI was 40%, to obtain the average annual ROI, Jo could divide 40% by 3 to yield 13.33% annualized. With this adjustment, it appears that although Jo’s second investment earned more profit, the first investment was actually the more efficient choice.
ROI can be used in conjunction with the rate of return [RoR], which takes into account a project’s time frame. One may also use net present value [NPV], which accounts for differences in the value of money over time, due to inflation. The application of NPV when calculating the RoR is often called the real rate of return.
Developments in ROI
Recently, certain investors and businesses have taken an interest in the development of new forms of ROIs, called "social return on investment," or SROI. SROI was initially developed in the late 1990s and takes into account broader impacts of projects using extra-financial value [i.e., social and environmental metrics not currently reflected in conventional financial accounts].
SROI helps understand the value proposition of certain environmental social and governance [ESG] criteria used in socially responsible investing [SRI] practices. For instance, a company may decide to recycle water in its factories and replace its lighting with all LED bulbs. These undertakings have an immediate cost that may negatively impact traditional ROI—however, the net benefit to society and the environment could lead to a positive SROI.
There are several other new variations of ROIs that have been developed for particular purposes. Social media statistics ROI pinpoints the effectiveness of social media campaigns—for example how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics ROI tries to identify the return attributable to advertising or marketing campaigns.
So-called learning ROI relates to the amount of information learned and retained as a return on education or skills training. As the world progresses and the economy changes, several other niche forms of ROI are sure to be developed in the future.
What Is ROI in Simple Terms?
Basically, return on investment [ROI] tells you how much money you've made [or lost] an investment or project after accounting for its cost.
How Do You Calculate Return on Investment [ROI]?
Return on investment [ROI] is calculated by dividing the profit earned on an investment by the cost of that investment. For instance, an investment with a profit of $100 and a cost of $100 would have an ROI of 1, or 100% when expressed as a percentage. Although ROI is a quick and easy way to estimate the success of an investment, it has some serious limitations. For instance, ROI fails to reflect the time value of money, and it can be difficult to meaningfully compare ROIs because some investments will take longer to generate a profit than others. For this reason, professional investors tend to use other metrics, such as net present value [NPV] or the internal rate of return [IRR].
What Is a Good ROI?
What qualifies as a “good” ROI will depend on factors such as the risk tolerance of the investor and the time required for the investment to generate a return. All else being equal, investors who are more risk-averse will likely accept lower ROIs in exchange for taking less risk. Likewise, investments that take longer to pay off will generally require a higher ROI in order to be attractive to investors.
What Industries Have the Highest ROI?
Historically, the average ROI for the S&P 500 has been about 10% per year. Within that, though, there can be considerable variation depending on the industry. For instance, during 2020, many technology companies generated annual returns well above this 10% threshold. Meanwhile, companies in other industries, such as energy companies and utilities, generated much lower ROIs and in some cases faced losses year-over-year. Over time, it is normal for the average ROI of an industry to shift due to factors such as increased competition, technological changes, and shifts in consumer preferences.