Question

what is criticisms of ROI and why the residual income may be a better indicator than the ROI?

Answer 1

Although ROI is widely used in evaluating performance, it is not a perfect tool. it is subject to following criticisims :

1. Just telling managers ti increase ROI is not enough. managers may not now how to increase ROI , they may increase ROI in a way that is inconsistent with the company's strategy or they may take steps that increase ROI in a short run but harm company in long run.
2. A manager who takes over a business segment typically inherent many committed costs over which the manager has no control. These committed costs may be relevant in assessing the performance of the business segment as an investment but make it difficult to fairly assess the performance of the manager relative to other manager,
3. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the company but that would have a negative impact on manager's performance evaluation.
4. The level of investment or capital employed can be difficult to measure and this can distort inter-firm comparisons.

RESIDUAL INCOME IS A BETTER INDICATOR THAN ROI :

It is another measure of performance evaluation based on investment in assets. It compares the profit actually earned to the minimum level of profit required for the business. It is profit earned less interest o minimum return on the capital that has been employed to generate the profit. It is considered a better method because it is an absolute measure as it measures in terms of money rather than in terms of percentage. It is ideal for comparisons across corporate divisions for companies of similar size and in similar sector.