Question

How is the performance of an investment center measured? What is the advantage of measuring residual income as well as ROI?

Answer 1

Investment Center;
-These are those centers, which are responsible for incurring costs, generating revenues as well as, making direct investments to maximise their returns.
-As it has the authority to directly deal in investments, the performance of an Investment center is measured by calculating the Return on Investment (ROI) made by it.

ROI = Net Income/Invested Capital*100
This basically tells, the benefit the company is receiving, by making a particular investment.

*There are some issues in using ROI to measure the performance of various investment centres.
-Firstly, it computes the performance in percentage terms, which doesn’t give a clear picture.
-Secondly, the results of various divisions can be manipulated.

To overcome these problems, there is yet another approach known as Residual Income that measures the performance in absolute terms.

Residual Income = Actual Income from Investment - Desired Income
where,
Desired Income = Invested Capital * Desired rate (which is Cost of capital)

Advantages of measuring Residual Income as well as ROI;

• The advantage of measuring both ROI and Residual Income, is that we get a clearer picture about the performance of investment centers, both in percentage and absolute terms.
• Also, by using Residual Income, we can compare the actual performance with the desired one. If actual income exceeds the desire, the division is more profitable in absolute terms.