Return on Investment and Residual Income

ROCE and residual income

The ROI gives companies the opportunity to compare the effectiveness and profitability of any number of investments. The residual income measures the net return that an investment achieves over and above the lowest return on its assets. Conversely, residual income is considered a better overall performance measure because it is an absolute measure. So in other words, it's money, not a percentage. When assets are valued at net book value, the ROI and residual income figures generally improve with increasing age of the assets.

Difference in ROI & residual income

The return on investment is a key figure that is used to measure the return on a company's investment. Enterprises use ROI to benchmark the effectiveness of a number of capital expenditures. The residual income is another way of assessing the investment return. This is the net profit from operations that an investment achieves above the requisite return on its capital employed.

In order to compute ROI, the investor adds the profit from the investment to the investment costs. Next, they split this number by the investment costs. Investment costs are also referred to as either the mean value of capital employed or the amount of capital investment. When calculating residual income, the investor first divides the operative income by the mean business asset (investment amount).

In the last stage, this figure is deducted from the result of the business to determine the residual income. The ROI is calculated as a percent of the total investment. The residual income is calculated in dollar terms if the investment exceeds the ROI. Enterprises that have a policy for assessing investment on the basis of ROI have started to change to the residual income approach.

This is mainly because the residual income approach provides more information. Manager look at ROI and make choices about whether the investment will meet minimal return criteria. The amount of additional investment in excess of the required return is not taken into account.

In the case of enterprises using the residual income approach, senior executives are assessed on the basis of year-on-year residual income increases rather than return increases. A key reason for moving from the ROI to the residual income approach is how executives select new investment.

As the two methodologies differ in the way they assess the return on investment, they have different final results. Applying the residual income model will help manageers make investment that is beneficial to the business as a whole. ROI approaches help business leaders make business decision on the basis of figures that relate to a particular business unit or area. Usually, a ROI applying executive rejects any ROI below the ROI of the actual business unit.

Whether the return on the investment is higher than the statutory return for the firm as a whole is irrelevant. Residual income provides more possibilities. A project whose return exceeds the corporate benchmark increases the residual income. Accepting a project that provides a return above the floor value is more rewarding for businesses.

Executives valued using the residual income approach make better investment choices than those valued using the return on investment approach.

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