Limitations, Criticism or Disadvantage of Residual Income Method:
The residual income approach has one major
disadvantage. It cannot be used to compare the performance of divisions
of different sizes.
You would expect larger divisions to have more
residual income than smaller divisions, not necessarily because they are
better managed but simply because they are bigger.
Example:
As an example consider the following residual income computations for
division X and division Y.
|
Average
operating assets (a)
Net operating income
Minimum required return: 10 × (a)
Residual income |
Division X
$1,000,000
========
$120,000
$100,000
-------------
20,000
======= |
Division Y
$2500,000
========
$40,000
$25,000
-------------
15,000
======= |
Observe that division X has slightly more
residual income than division Y, but that division X has $1000,000 in
operating assets as compared to only $250,000 in operating assets for
division Y. Thus, division X's greater residual income is probably more
a result of its size than the quality of its management. In fact, it
appears, that the smaller division is better managed, since it has been
able to generate nearly as much residual income with only one fourth as
much much in operating assets to work with. This problem can be reduced
by focusing on the percentage change in residual income from year to year
rather than on the absolute amount of the residual income.
|
