ROI and Residual Income in Performance Measurement

Answer to Question 3:
a. Return on Investment or the ROI represents the total return generated
by the company over the total investments made by the company
during the same period of time. Higher the ROI better it is for the
company as the company is utilising the investments in an efficient way
and generating greater returns for the investors.
Here, for Cloths Ltd the ROI of the Trousers division at 20% is higher
than the ROI of 15% for shirts division. Based on ROI, it is evident
that Trousers division is more successful. If we see in absolute
terms the division is contributing $100,000 against $450,000
contributed by Shirts. Even though the Trousers division has better
ROI, its contribution to the total net income of the company is lower in
absolute terms.
b. Residual Income (RI) can be defined as the total amount of net income
that remains with the company after paying for the minimum return
required for the investors. It is computed as Profit – (Minimum Rate of
Return * invested capital).
For Cloths Ltd, the RI under three different returns is as below:
Computation of Residual Income
Particulars Shirts Trousers
Average Invested Capital (A) $30,00,000 $5,00,000
Profit (B) $4,50,000 $1,00,000
Scenario I - Rate of return (12%)
Residual Income = Profit - (12%
* Average Invested Capital) $90,000 $40,000
Scenario II - Rate of return (15%)
Residual Income = Profit - (15%
* Average Invested Capital) $0 $25,000
Scenario III - Rate of return (18%)
Residual Income = Profit - (18%
* Average Invested Capital) -$90,000 $10,000

c. Performance measures are vital to any organization as it lets the
manager in planning, controlling and decision making. ROI is a
performance measure that reflects the percentage return generated by
the company over the invested capital. A high ROI is generally better
but at times the results of ROI can be misleading as the %age return
camouflages the relative return generated and thus there exists a
possibility of rejecting financially sound opportunities.
Based on lower ROI of a given division or departments whose required
return may be more than the ROI, the investment might be rejected
but chances are that the ROI can still be greater than the company’s
required rate of return and thus the investment would have been
beneficial for the company.
Residual income overcomes this as it computes the income left with
the firm after it has paid for the minimum required return from the
investment. RI evaluates the project or investment in totality and is
computed based on company’s required rate of return.

Answer to Question 4:
The sell off or process further decisions can be made on the basis of
incremental profit that is generated for the company in case the products
are processed further and then sold. Here, we will first compute the
incremental profit that is generated in case all the units are processed
further:
Product Incrementa
l Revenue Cost Incrementa
l net profit
Small Shoes $90,000 $1,20,000 -$30,000
Average
Shoes $30,000 $40,000 -$10,000
Large Shoes $50,000 $40,000 $10,000
We see that for small shoes and average shoes category the company’s
incremental profit is negative and thus the company should not process
them further and sell them at the split off point only in order for them to be
profitable for the company.
The optimal schedule of production for the company in order to maximize
the profit is as below:
 Small Shoes: 25,000 units sold at split off point
 Average Shoes: 5,000 units sold at split off point
 Large Shoes: 10,000 units processed further and then sold