The residual income (RI) for a division is calculated by deducting from the divisional profit an imputed interest charge, based on the investment in the division.
The return on investment (ROI) is the divisional profit expressed as a percentage of the investment in the division.
Both methods use the same basic figure for profit and investment, but residual income produces an absolute measure whereas the return on investment is expressed as a percentage.
Both methods suffer from disadvantages in measuring the profit and the investment in a division which include the following.
(i) Assets must be valued consistently at historical cost or at replacement cost. Neither valuation basis is ideal.
(ii) Divisions might use different bases to value inventory and to calculate depreciation.
(iii) Any charges made for the use of head office services or allocations of head office assets to divisions are likely to be arbitrary.
In addition, return on investment suffers from the following disadvantages.
(i) Rigid adherence to the need to maintain ROI in the short term can discourage managers from investing in new assets, since average divisional ROI tends to fall in the early stages of a new investment. Residual income can overcome this problem by highlighting projects which return more than the cost of capital.
(ii) It can be difficult to compare the percentage ROI results of divisions if their activities are very different: residual income can overcome this problem through the use of different interest rates for different divisions.
