![]() ![]() is a company engaged in production and distribution of computers and printers. It is quite possible that some departments may be able to accept a lower ROI project while a higher ROI project at another department may not get the required investment. Since capital is a scarce resource, a company may not be able to arrange money for all projects with positive residual income. Disadvantage of Residual Incomeīut residual income itself suffers from a bias, it does not allow for ranking of departments based on the dollars they earn per $100 of investment. This is one of the advantages that the residual income approach has over the ROI approach. If department managers are evaluated based on the residual income that their departments generate, they have an incentive to accept all such projects which earn a return greater than the minimum required rate of return. However, from the company’s perspective, accepting the project is the right thing to do because the project's return of 16.67% is higher than the minimum required return. The minimum required return is 15% and the department manager is considering a project that will earn $50,000 and require additional capital of $300,000. Let us consider a department whose current operating income is $200,000 and its asset base is $1,000,000. It creates an incentive for managers to not invest in projects which reduce their composite ROI even though those projects generate a return greater than the minimum required return. Even though ROI is the most popular measure, it suffers from a serious drawback. Return on investment (ROI) is another performance evaluation tool which equals the operating income earned by a department divided by its asset base. ![]() It is calculated by dividing the sum of opening and closing balances of the operating assets of the department by 2. It is based on the company's cost of capital and the risk of the project.Īverage operating assets of the department represents the total capital employed by the department. Required return is the opportunity cost of the funds for the company. Residual Income = Controllable Margin - Required Return × Average Operating AssetsĬontrollable margin (also called segment margin) is the department's revenue minus all such expenses for which the department manager is responsible. Residual income of a department can be calculated using the following formula: Residual income also features in corporate finance and valuation where it equals the difference between a company's net income and the product of the company's equity capital and its cost of equity. Departments with positive residual income are good candidates for expansion. ![]() A positive residual income means that the department has met the minimum return requirement while a negative residual income means that the department has failed to meet it. Residual income approach is useful in allocating resources among projects or investments. It is calculated by subtracting the product of a department's average operating assets and the minimum required rate of return from its controllable margin. In management accounting, residual income represents any excess of a department's income over the opportunity cost of the capital that it employs.
0 Comments
Leave a Reply. |