Management Accounting 101: Performance Measurement and Control - Return on Investment, ROI and Residual Income RI

What This Is

Return on Investment (ROI) and Residual Income (RI) are two essential metrics used by managers to evaluate the profitability of investments and projects. ROI measures the return generated by an investment relative to its cost, while RI measures the return generated by an investment relative to its cost and the cost of capital. For example, Toyota uses ROI to evaluate the profitability of its manufacturing investments, ensuring that each investment generates a sufficient return to justify its cost.

Key Frameworks & Metrics

• Return on Investment (ROI) = Net Income / Total Investment – measures the return generated by an investment relative to its cost.
• Residual Income (RI) = Net Income - (Capital Invested × WACC) – measures the return generated by an investment relative to its cost and the cost of capital.
• Economic Value Added (EVA) = NOPAT - (Capital Invested × WACC) – measures true economic profit after charging for the cost of capital.
• Net Operating Profit After Taxes (NOPAT) = Earnings Before Interest and Taxes (EBIT) × (1 - Tax Rate) – measures the operating profit after taxes.
• Weighted Average Cost of Capital (WACC) = (Debt × Cost of Debt) + (Equity × Cost of Equity) / Total Market Value of Equity and Debt – measures the cost of capital.
• Capital Invested = Total Assets - Current Liabilities – measures the total investment in an asset or project.
• Net Income = Revenue - Total Costs – measures the profit generated by an investment or project.
• Total Investment = Initial Investment + Any Additional Investments – measures the total investment in an asset or project.
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit – tells you how many units must be sold to cover all costs.

Step-by-Step Process

1. Identify the investment or project: Clearly define the investment or project being evaluated.
2. Determine the total investment: Calculate the total investment in the asset or project.
3. Calculate the net income: Calculate the net income generated by the investment or project.
4. Calculate the ROI: Calculate the ROI using the formula ROI = Net Income / Total Investment.
5. Calculate the RI: Calculate the RI using the formula RI = Net Income - (Capital Invested × WACC).
6. Compare the ROI and RI: Compare the ROI and RI to determine if the investment or project is generating a sufficient return.

Common Mistakes

• Mistake: Treating all costs as relevant when evaluating an investment or project.
• Correction: Only consider avoidable costs when evaluating an investment or project.
• Mistake: Ignoring qualitative factors when making a make-or-buy decision.
• Correction: Consider both quantitative and qualitative factors when making a make-or-buy decision.
• Mistake: Using ROI alone without considering residual income or EVA.
• Correction: Use a combination of ROI, RI, and EVA to evaluate the profitability of an investment or project.

Decision-Making Tips

• When evaluating an investment or project, always consider the cost of capital: Use RI and EVA to evaluate the profitability of an investment or project.
• When making a make-or-buy decision, consider both quantitative and qualitative factors: Use ABC to isolate avoidable costs and consider strategic factors.
• When faced with a decision, always consider the long-term implications: Use a combination of ROI, RI, and EVA to evaluate the long-term profitability of an investment or project.

Quick Practice Scenario

A division rejects a project because its ROI would drop from 18% to 17%. By how much would residual income change if the project cost is $1M and the required rate of return is 12%?

Answer: Residual income would decrease by $20,000.

Explanation: The project's ROI would drop from 18% to 17%, resulting in a decrease in residual income of $20,000.

Last-Minute Cram Sheet

• ROI = Net Income / Total Investment
• RI = Net Income - (Capital Invested × WACC)
• EVA = NOPAT - (Capital Invested × WACC)
• NOPAT = EBIT × (1 - Tax Rate)
• WACC = (Debt × Cost of Debt) + (Equity × Cost of Equity) / Total Market Value of Equity and Debt
• Capital Invested = Total Assets - Current Liabilities
• Net Income = Revenue - Total Costs
• Total Investment = Initial Investment + Any Additional Investments
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit 'Fixed costs' are only fixed in the short run within a relevant range – outside that range, they can change. ROI alone is not sufficient to evaluate the profitability of an investment or project. Residual income and EVA are more comprehensive metrics than ROI.