Definitions and meanings:
Return on investment:
Return on investment (ROI) is a measure which calculates the efficiency of an investment by calculating percentage of return earned by that investment.
Residual income:
Residual income (RI) is the amount of income an investment opportunity generates above the minimum level of rate of return.
Formulas and example:
The formulas for the calculation of return on investment (ROI) and Residual income (RI) are given below:
Return on investment = (Profits or return/Total Long-term investment) × 100
Residual income = Net operating Income – (Average operating assets × Minimum rate of return)
For example, Maria Enterprises is a small private company that manufactures clocks. Some line items from the financial statements of Maria Enterprises are:
| Capital invested | $40,000 |
| Long-term liabilities | $68,000 |
| Short-term liabilities (2017) | $7,980 |
| Short-term liabilities (2018) | $9,990 |
| Profit earned for the year 2018 | $13,200 |
| Profit earned for the year 2017 | $12,600 |
| Rate of return | 10% |
Assuming that the capital structure of Maria Enterprise does not change, the ROI or return on investment for the year 2017 and 2018 would be:
This would mean that total return for Maria Enterprise on its long-term investment is 11.7% and 12.2% in the years of 2017 and 2018 respectively.
For the calculation of RI or residual income for Maria Enterprise, the minimum required rate of return of the company would be considered in order to calculate the minimum income possible to earn on the available investment. If operating assets of company are assumed to be $79,000 and operating income equal to the profits earned, RI would be:
Residual Income (2017)
= Net operating Income – (Average operating assets × Minimum rate of return)
=$12,600 – ($79,000 × 10%)
= $12,600 – $7,900
= $4,700
Residual Income (2018)
= Net operating Income – (Average operating assets × Minimum rate of return)
= $13,200 – ($79,000 × 10%)
= $13,200 – $7,900
= $5,300
So, the residual or additional income for Maria Enterprise would be $4,700 and $5,300 for years of 2017 and 2018 respectively.
Difference between ROI and RI:
The main points of difference between ROI and RI are given below:
1. Implementation of method:
RI is a more flexible approach which can be manipulated easily. This is because the change in cost of capital of the company can change the results obtained by the RI calculation. The calculation of cost of capital for a company is itself a complicated task for the business because it takes into account the expected return of both shareholders and creditors. ROI is an approach which is hard to manipulate as it includes variables that are properly documented and traceable.
2. Scope:
The ROI shows the return to a company in percentage terms. This percentage can be calculated for a product, a division or the whole organization. RI, on the other hand, shows return that a company is earning in monetary terms. It basically highlights the favorableness of an investment by comparing it with the least favorable option which is the minimum amount of interest a company could have earned on its investment. This is the reason why RI can help in decision-making while considering new investments.
3. Criteria of decision-making:
A project is deemed favorable if the ROI of that project is equal to or more than the target ROI of the company or project. If, ROI is calculated for a new project, business may alter its target ROI based on the industry or product or market related to the new project. As RI method is used to assess the financial efficiency of invested capital, it is not usually used for specific decision-making rather it can aid management to understand the level of opportunity cost upon their investment decisions.
4. Application:
Unlike profits or operating income of a company, return on investment shows the amount of returns or losses that a company is earning or bearing if compared to the capital invested. This measure can be used to evaluate many areas of business including the handling of inventory or stock (ordering, holding, operating cycles etc.), the pricing strategy of the company and future investment decisions based on the target ROI of the company. Whereas, the residual income highlights the ‘opportunity cost’ for the invested capital of a business. This measure highlights the real value of capital invested and can identify ‘income valuation’ of a project by showing the compensation that the company is getting above the minimum possible ROI.
ROI vs RI – tabular comparison
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| Implementation of method | ||||
| Is difficult to manipulate because based on absolute figures. | Is prone to manipulation because involves cost of capital percentage which can be changed. | |||
| Scope | ||||
| Can be used to calculate percentage return for product, division or the whole organization. | Can show the incremental profitability of an investment especially new investment in monetary terms. | |||
| Criteria of decision-making | ||||
| Can be used for specific investment decisions for new projects or evaluation of current projects. | Can help management understand the efficacy of their investment decisions. | |||
| Application | ||||
| Shows in percentage terms the return on long-term investments for a business. | Shows the incremental income after deducting the notional interest from the operating income of a business. | |||
Conclusion:
Both the return on investment and residual income methods are used by the management of companies to make reasonable investment decisions. Where return on investment indicates the percentage of return an investment or overall capital of a company is earning, residual income highlights the success of an investment. Management of a company may need to consider more factors while taking decision about the investment of long-term capital, but these decisions could be made more accurately if these methods are used but only if reliable variables are inculcated.
