Return on Investment (ROI) is a crucial metric for evaluating financial performance. It measures how efficiently a company uses its assets to generate profit, comparing divisions or companies of different sizes. ROI helps managers make informed decisions about resource allocation and investment strategies.

Residual income offers an alternative perspective, considering the cost of capital in performance evaluation. It encourages investment in profitable projects regardless of size, avoiding potential pitfalls associated with ROI-based decision-making. Understanding both metrics is essential for balanced financial management and strategic planning.

Return on Investment (ROI)

Calculation and significance of ROI

• ROI formula measures profitability relative to invested capital $ROI = \frac{Operating Income}{Average Operating Assets} \times 100%$
• Components include operating income (profit from core business activities) and average operating assets (resources used to generate income)
• Evaluates performance by comparing divisions or companies of different sizes (Walmart vs local grocery store)
• Indicates efficiency in utilizing assets to generate profit (manufacturing plant productivity)
• Higher ROI suggests better performance benchmarked against industry standards or company targets (15% ROI in retail vs 8% in utilities)

Concept of residual income

• Profit remaining after deducting required rate of return on invested capital
• Formula calculates excess profit $Residual Income = Operating Income - (Required Rate of Return \times Average Operating Assets)$
• Considers cost of capital aligning with overall company goals (10% required return)
• Encourages investment in profitable projects regardless of size (small R&D project vs large factory expansion)
• Avoids potential dysfunctional decision-making associated with ROI (rejecting profitable projects that lower overall ROI)

ROI vs residual income

• Both measure financial performance using operating income in calculations
• ROI expressed as percentage while residual income is absolute amount ($500,000 residual income)
• Residual income accounts for cost of capital ROI does not (8% cost of capital considered)
• ROI favors smaller investments residual income is size-neutral (choosing between $1M and $10M projects)
• ROI may lead to rejection of profitable projects that lower overall ROI (9% ROI project rejected due to 10% overall ROI)
• Residual income encourages acceptance of all projects exceeding required return (positive residual income)

Impact of investments on metrics

• New investments affect ROI based on project's ROI relative to current ROI (12% project ROI vs 10% current ROI)
• Larger investments have greater impact on overall ROI (1% change from $100M vs $10M investment)
• Residual income increases if project's return exceeds required rate (15% return vs 10% required)
• Investment size doesn't affect residual income if return equals required rate (10% return on any size investment)
• Short-term effects may show temporary decrease in ROI and residual income (initial costs of new product launch)
• Long-term benefits often outweigh short-term negative impacts (R&D expenses leading to future profitable products)
• Strategic implications involve balancing growth opportunities with performance metrics (expanding into new markets vs maintaining high ROI)
• Aligning investment decisions with company's long-term objectives (sustainability initiatives vs immediate profit maximization)