Define ROI and RI and explain why RI can mitigate some ROI drawbacks.

Define ROI and RI and explain why RI can mitigate some ROI drawbacks.

• A. ROI = operating profit / assets; RI = operating profit − (minimum required return × assets). RI accounts for cost of capital and encourages investing in profitable assets; ROI can discourage investments that lower overall ROI.
• B. ROI = net income / equity; RI = net income − (minimum required return × equity).
• C. ROI = gross profit / sales; RI = operating cash flow − required return.
• D. ROI and RI are identical metrics; there is no distinction.

Answer: (A)

ROI measures profitability relative to the asset base, defined as operating profit divided by assets. It tells you how much return is being generated per unit of assets employed. Residual income (RI) takes that a step further by charging for the cost of the capital used: RI = operating profit − (minimum required return × assets). The minimum required return represents the cost of capital, so RI shows the amount of profit remaining after all capital costs have been covered. This matters because ROI, being a relative measure, can discourage managers from taking on new investments that would lower the division’s ROI even if those investments would be profitable overall. RI avoids that pitfall by ensuring that only profits above the capital charge are considered value-added. If a project earns at least the minimum return, it contributes positively to RI, encouraging value-adding investments and better alignment with shareholder value.

ROI measures profitability relative to the asset base, defined as operating profit divided by assets. It tells you how much return is being generated per unit of assets employed. Residual income (RI) takes that a step further by charging for the cost of the capital used: RI = operating profit − (minimum required return × assets). The minimum required return represents the cost of capital, so RI shows the amount of profit remaining after all capital costs have been covered.

This matters because ROI, being a relative measure, can discourage managers from taking on new investments that would lower the division’s ROI even if those investments would be profitable overall. RI avoids that pitfall by ensuring that only profits above the capital charge are considered value-added. If a project earns at least the minimum return, it contributes positively to RI, encouraging value-adding investments and better alignment with shareholder value.