Return on investment (ROI) shows a division’s profit as a percentage of the capital it uses; residual income (RI) deducts a charge for that capital at the cost of capital and leaves an absolute amount. RI encourages managers to accept any project that earns more than the cost of capital, while ROI can lead them to turn down good projects that would dilute their current percentage. ROI, however, is easier to compare across divisions of different sizes.
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How are ROI and residual income calculated?
ACCA’s technical articles on divisional performance give the formulas:
- ROI = controllable (or traceable) profit divided by controllable (or traceable) investment, as a percentage.
- RI = controllable (or traceable) profit less imputed interest, where imputed interest is the controllable (or traceable) investment multiplied by the cost of capital.
Use controllable figures when judging the manager and traceable figures when judging the division; the distinction is explained in cost, profit and investment centres. ACCA’s advanced article says the cost of capital is typically the weighted average cost of capital, though a company may instead set a target rate of return, in which case positive RI shows the division beating the target.
Why can ROI lead to the wrong decision?
ACCA’s performance measurement article uses this example. Division X has net assets of $10m, earns $2.2m a year and has a cost of capital of 10%. It is considering two proposals. Proposal 1 invests a further $1m to earn $0.15m a year. Proposal 2 disposes of assets with a book value of $2.3m, reducing profit by $0.3m, with the proceeds going to head office.
| Profit | Net assets | ROI | Imputed interest at 10% | RI | |
|---|---|---|---|---|---|
| Current | $2.2m | $10.0m | 22.0% | $1.0m | $1.2m |
| After Proposal 1 | $2.35m | $11.0m | 21.4% | $1.1m | $1.25m |
| After Proposal 2 | $1.9m | $7.7m | 24.7% | $0.77m | $1.13m |
Proposal 1 earns 15% against a 10% cost of capital, so it is good for the company, yet it lowers divisional ROI and a manager judged on ROI may reject it. Proposal 2 gives up assets earning 13%, which is bad for the company, yet it raises ROI and the manager may accept it. ACCA describes both as dysfunctional decisions. RI moves in the right direction in each case: up for Proposal 1, down for Proposal 2.
ACCA’s advanced article makes the same point with a division whose current ROI is 15.9%, offered a project returning 12% when the cost of capital is 10%. Judged on ROI the manager will not invest; judged on RI they will.
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Why does residual income fit better with investment appraisal?
ACCA notes that RI ties in with net present value, which is theoretically the best way to make investment decisions: the present value of a project’s residual income equals its NPV, so in the long run maximising RI also maximises NPV and shareholder wealth. See investment appraisal using NPV and IRR.
RI is also flexible. Because the charge uses a cost of capital, a higher rate can be applied to riskier divisions or projects. ACCA illustrates why an absolute measure helps: borrowing $100 to earn 25% gives a higher percentage than borrowing $1m to earn 15%, but after a 10% borrowing cost the first leaves $15 a year and the second $50,000.
Where does ROI have the advantage?
ROI is a percentage, so it compares divisions of different sizes directly and is easily understood by managers used to margins and returns. RI, being absolute, tends to be higher in a larger division simply because of its size rather than better management. ACCA describes this as making comparison difficult but not impossible; one approach is to compare each division’s RI with its own budget or prior year rather than with other divisions.
ROI is also familiar from external analysis. ACCA’s advanced article explains that return on capital employed is very similar but better suited to a company as a whole, or to comparing a division with an external company using divisional profit. See return on capital employed.
What problems do ROI and RI share?
- Defining controllable profit and investment can be difficult.
- Short termism. A project with a positive NPV can show poor ROI and RI in its early years, so managers may reject it.
- Ageing assets. If assets are valued at net book value, both measures improve as assets get older, which can encourage managers to keep outdated plant.
- Asset valuation and accounting policies. A division whose property has been revalued shows a higher asset base and lower ROI and RI than one carrying assets at old cost.
- Cost of capital. Both need an estimate, which can be hard to make. ACCA notes that in practice investment centres are often charged only the debt element of capital, which understates the true cost.
- Single figure. Neither measure says why performance changed, which is why many groups add non financial measures through a balanced scorecard.
How should the investment base be measured in a year of new spending?
ACCA’s advanced article gives a two division example with a 10% cost of capital. Division B invested $50m in new machinery in the second half of the year and its product launch was supported by head office marketing. On year end capital employed of $285m and traceable profit of $39m, its ROI fell to 13.7% and RI to $10.5m, from 18.7% and $20.0m the year before, behind Division A at 15.9% and $11.5m.
Because the new product only traded for half the year, ACCA recalculates Division B using average capital employed of $257.5m, giving ROI of 15.1% and RI of $13.3m. On that basis B’s RI is ahead of A’s, though its ROI is still lower. The lesson is that measuring new investment at its full year end value, before it has earned a full year’s return, can punish managers for investing.
How does economic value added relate to residual income?
ACCA explains that economic value added (EVA) follows the same logic as RI: net operating profit after tax less a charge for capital at the weighted average cost of capital. The difference is a series of adjustments to accounting figures, such as capitalising spending that builds value (research, marketing, training), using replacement cost for assets rather than net book value, and removing non cash items such as doubtful debt provisions. EVA reduces the distortions from accounting policies but is more complex to compute.
What mistakes come up most often?
- Using ROI alone as a bonus target, which rewards shrinking the asset base.
- Comparing RI across divisions of very different sizes without adjustment.
- Mixing controllable and traceable figures in the same calculation.
- Charging a cost of capital that reflects only borrowing costs.
- Ignoring the age and valuation basis of each division’s assets.
- Judging a division in the year of a major investment on year end capital employed without looking at the trend.
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Related Accountapedia entries
- Internal transfer pricing between divisions
- DuPont analysis of return on equity
- Asset turnover ratio
- Return on equity
- The Altman Z score
- Reviewing useful lives and residual values
Sources
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.