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 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 assets Net operating income
Minimum required return
Residual 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.
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