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Management Information
Performance Management
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Performance Evaluation
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Feedback Control
Information produced within the organization (ManagementControl Reports) with the purpose of helping managementand other employees with control decisions
o Step1: Plans and targets are set for future (e.g. Sales budget)
o Step 2: Plans are put into operations (e.g organize business recourses
to achieve the sales target)o Step 3: Actual results are recorded and analyzed (actual results are
reported back to management)
o Step 4: Information about actual results in feedback
o Step 5: The feedback is used by management to compare (managerscompare actual results against plan)
o Step 6: Compare plan with actual results and things can be done Take control action (work longer hours, spend on advertising, price discount)
Decide to do nothing
Alter plan or target
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Feedback Loop in the control Cycle
Plan, targetor budget Compare
actual resultswith plan
Control Action
MeasureOutput
OPERATIONS
INPUT
RESOURCES
OUTPUTS
(e.g. actual output,revenues, costs)
Feedback ofInformation
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Features of Effective Feedback
Reports should be clear and comprehensive
Exception principle should be applied so that significant differencebetween the target and actual results should be highlighted forinvestigation- areas conforming to plans should be given lessprominence in the management control report
The controllable costs and revenues should be separately identified Reports should be produced on a regular basis to ensure that the
continual control is exercised
Reports should be available to management in a timely fashion
Information should be sufficiently accurate for the purpose
intended Irrelevant details should be excluded from the report
Reports should be communicated to the managers who has theresponsibility and authority to act on the information
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Behavioral impact of performance
management
Performance measures lead to lack of goalcongruence- managers seek to improve theirperformance on the basis of the indicators used,even if this is not in the best interest of the
organization as a whole Example- production manager may be encouraged to
achieve and maintain high production level and to reducecosts, particularly if his bonus is linked to these factors-this may results in high level of slow moving inventory-
resulting in adverse effect on the companys cash flow Thus the managers behavior has been distorted by
the control system
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Behavioral impact of performance
management.. Hopwoods 3 distinct ways of
using budgetary informationStyle of evaluation CommentBudget constrained The managers performance is primarily evaluated upon the
basis of his ability to continually meet the budget on a short-term
basis.
This criterion of performance is stressed at the expense of other
valued and important criteria and the manager will receiveunfavorable feedback from his supervisor if, for instance, his
actual costs exceeds the budgeted costs regardless of other
considerations
Profit Conscious The managers performance is evaluated on the basis of hisability to increase the general effectiveness of his units operations
in relation to the long-term purposes of the organization
Non-accounting The budgetary information plays a relatively unimportant part inthe superiors evaluation of the managers performance
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A Summary of the effects of
evaluationBudget
Constrained
Profit
Conscious
Non
Accounting
Involvement with costs High High Low
Job-related tension High Medium Medium
Manipulation of accounting reports (bias) Extensive Little Little
Relations with the supervisor Poor Good Good
Relations with colleagues Poor Good Good
Research has shown no clear performance for one style over another
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Budget bias
Manipulation of budget is likely to occur if the manager isunder pressure to achieve short-term budget targets
In the process of preparing budgets, managers mightintroduce slack into their estimates- overestimate costs or
underestimate revenues In controlling actual operations managers might ensure that
their spending rises to meet their inflated budget, otherwisethey will be blamed for careless budgeting
After a mediocre results, managers might overstate revenuesand understate cost estimates, to make immediate favorableimpact by promising better performance in the future
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Responsibility Centers
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Divisionalisation
As companies grow and possibly also spreadgeographically, it is likely that they will considersome form of divisionalization
This involves splitting the company into divisions,e.g.
according to location or
according to the product or service provided
The division managers are given the authority tomake decisions concerning the activities of theirdivisions
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Decentralization
In general, a divisional structure will lead to
decentralization of the decision making
process
Division managers may have the freedom to
set selling prices, choose suppliers and make
output decisions and so on
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Factors effecting degree of
decentralization Management style: Authoritarian style is likely to mean that decision making is
centralized
Size of the organization: decentralization tends to increase as organization grows
Extent of activity diversification: greater diversification activities will lead to moredecentralization
Effectiveness of communication: decentralization can only operate if information
is communicated effectively both up and down the organization The ability of management: the more able the management team, the more
decentralization is likely results
The speed of technological advancement: Managers lower down the organizationare more likely to be familiar with changing technology, therefore decentralizationwould be more appropriate
The geography of location and the extent of local knowledge needed: if anorganization is spread over a wide range of locations then decentralization is likelyto be most effective. Local managers would make more effective decisions basedon their knowledge of local markets
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Decentralization in Organizations
Benefits ofDecentralization
Top managementfreed to concentrate
on strategy.
Lower-level managersgain experience indecision-making. Decision-making
authority leads tojob satisfaction.
Lower-level decisionoften based onbetter information.
Lower-level managerscan respond quickly to
customers.
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Decentralization in Organizations
Disadvantages ofDecentralization
Lower-level managersmay make decisions
without seeing thebig picture.
May be a lack ofcoordination among
autonomousmanagers.
Lower-level managers
objectives may notbe those of theorganization. May be difficult to
spread innovative ideasin the organization.
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Responsibility Accounting
Responsibility accounting is the term used to describedecentralization of authority, with the performance of thedecentralization units or responsibility centers measured interms of accounting results.
There are four main type of responsibility centers
Cost Center
Revenue Center
Profit Center and
Investment Center
In the weakest form of decentralization, cost center orrevenue center might be used
As decentralization becomes stronger, responsibilityaccounting framework will be based around profit centers
Decentralization in its strongest form means that investment
centers are used
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Cost, Profit, Revenue and
Investments Centers
ResponsibilityCenter
CostCenter
RevenueCenter
InvestmentCenter
Cost, profit,Revenue and
investmentcenters are allknown asresponsibilitycenters.
ProfitCenter
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Cost CenterA segment whose
manager has controlover costs, but not
over revenues
or investment funds.
Cost, Profit, and Investments
Centers
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Profit CenterA segment whose
manager hascontrol over bothcosts andrevenues,
but no control overinvestment funds.
RevenuesSales
InterestOther
Costs
Mfg. costsCommissions
Salaries
Other
Cost, Profit, and Investments
Centers
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Investment Center
A segment whosemanager has controlover costs, revenues,and investments in
operating assets.
Corporate Headquarters
Cost, Profit, and Investments
Centers
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Responsibility Centers
Salty Snacks
Product Manager
Bottling Plant
Manager
Warehouse
Manager
Distribution
Manager
Beverages
Product Manager
Confections
Product Manager
Operations
Vice President
Finance
Chief FInancial Officer
Legal
General Counsel
Personnel
Vice President
Superior Foods Corporation
Corporate Headquarters
President and CEO
Cost
Centers
InvestmentCenters
Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
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Responsibility Centers
Salty Snacks
Product Manager
Bottling Plant
Manager
Warehouse
Manager
Distribution
Manager
Beverages
Product Manager
Confections
Product Manager
Operations
Vice President
Finance
Chief FInancial Officer
Legal
General Counsel
Personnel
Vice President
Superior Foods Corporation
Corporate Headquarters
President and CEO
Profit
CentersSuperior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
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Responsibility Centers
Salty Snacks
Product Manager
Bottling Plant
Manager
Warehouse
Manager
Distribution
Manager
Beverages
Product Manager
Confections
Product Manager
Operations
Vice President
Finance
Chief FInancial Officer
Legal
General Counsel
Personnel
Vice President
Superior Foods Corporation
Corporate Headquarters
President and CEO
Cost
CentersSuperior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
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Responsibility Accounting..
Type of
responsibility
Center
Manager has control over Principal
performance
measures
Cost Center Controllable Costs Variance Analysis
Efficiency measures
Revenue Center Revenues only Revenues
Profit Center Controllable Costs
Sales price (including transfer price)
Profit
Profit margin
Investment CenterControllable costs
Sales price (including transfer prices)
Output volume
Investment in non-current assets and
working capital
Return on investment
Residual income
Other financial ratios
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Decentralization and Segment
Reporting
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A segment is any part
or activity of an
organization about
which a managerseeks cost, revenue,
or profit data. A
segment can be . . .
A Sales Territory
A Service Center
An Individual StoreQuick Mart
Decentralization and Segment
Reporting
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Traceable and Common Fixed
Costs
In segment reports, traceablefixed costs should be distinguished
from common fixed costs.
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Traceable costs arise because of the existence of aparticular segment and would disappear over time if
the segment itself disappeared.
No computerdivision means . . .
No computerdivision manager.
Identifying Traceable Fixed Costs
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Common costs arise because of the overalloperation of the company and would not disappear
if any particular segment were eliminated.
No computerdivision but . . .
We still have acompany president.
Identifying Common Fixed Costs
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Performance Measures
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General requirements for effective
performance measures
Promote goal congruence- by providingincentives to promote the responsibilitycenters performance in line with overall
company objectives Incorporate factors over which centers
manager has control
Should encourage the pursuit of long termobjectives as well as short term, budgetconstraints objectives
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Potential problems with
inappropriate performance measures Managers may manipulate information in order to ensure
achievement of the KPIs
The measure might cause de-motivation and stress relatedconflictbetween a manager and the managers subordinate,superiors, or fellow managers
The measure might promote excessive concern for thecontrol of short term costs, possibly at the expense of longerterm profitability
They might lead to the assessment of a responsibility centeras an isolated unit, rather than as an integral part of thewhole organization
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Performance measures for a
cost center
Cost variance, which are the difference
between the budgeted or standard costs and
the actual costs
Cost per unit
Cost per employee
Other non-financial measures such as the rate
of labor turnover or staff absenteeism
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Performance measures for a
revenue center
Revenue variance, which are the difference
between the budgeted or standard revenue
and the actual revenue achieved
Revenue earned per employee
Percentage market share achieved
Growth in revenue
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Performance measure for a
profit center
Gross profit margin, which is the difference
between the selling price and the direct costs
incurred, often expressed as a percentage of
the selling price
Operating profit margin, which is the gross
profit less indirect costs incurred such as
administrative salaries, often expressed as apercentage of the selling price
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Performance measures for an
Investment Center
Working Capital Ratios
Liquidity measures such as current ratio and thequick (liquidity) ratios
Rate of inventory turnover Receivable and payable periods
Return achieved in the division in relation tolevel of investment
Return on Investment (ROI)
Residual Income (RI)
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Rate of inventory turnover
The rate of inventory turnover monitors how many timesinventory turns over during the trading period
In general the rate of turnover should be as high as possible-since this means inventory is lower, reducing costs such asspace costs, insurance costs, obsolescence write-off and thecost of capital being tied up
However, potential sales might be forgone if inventory is solow that customers needs cannot be met
Cost of Sales
Average Inventory
Rate of inventory turnover =
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Receivable collection period
This KPI monitors how long on average it takes to collect debts
The collection period can also be measured in months, in which case theratio calculation would be multiplied by 12 instead of 365
The lower this period, the lower the capital cost of money invested inreceivable balances and the lower the risk of bad debts
However, customers may go elsewhere if the credit period offered is toolow
Receivable collection period (in days) =Average receivables
Average sales revenueX 365
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Payables payment period
This KPI monitors how long on average the company waitsbefore paying its suppliers
The payment period can also be measured in months, inwhich case the ratio calculation would be multiplied by 12instead of 365
In general this period should be as high as possible.
However supplier goodwill may be lost if the period of credittaken is too long.
Continuity of supply could also be disrupted if suppliers placeoverdue accounts on stop
Payables payment period =Average payables
X 365Annual purchase
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Return on Investment (ROI)
ROI is often used as a measure to monitor the performance of investmentcenter.
It shows how much profit has been earned in relations to the amount ofcapital invested in the center
The main reason for widespread use of ROI is that it ties in directly withthe accounting system and is identifiable from the income statement and
balance sheet
ROI facilitates comparisons but ranking is difficult as the measure is arelative percentage.
ROI = Controllable divisional profit X 100%Divisional capital employed
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ROI = Net operating incomeAverage operating assets
Cash, accounts receivable, inventory,plant and equipment, and other
productive assets.
Income before interestand taxes (EBIT)
Return on Investment (ROI)
Formula
Return on Investment (ROI)
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ROI = Net operating incomeAverage operating assets
Margin =Net operating income
Sales
ROI = Margin Turnover
Return on Investment (ROI)
Formula
Turnover =
Sales
Average operating assets
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There are three ways to increase ROI . . .
Increase
Sales
ReduceExpenses
Reduce
Assets
Increasing ROI
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. The
required rate of return for the company is 15%.What is the divisions ROI?
a. 25%
b. 5%
c. 15%d. 20%
Quick Check
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions ROI?
a. 25%
b. 5%
c. 15%d. 20%
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%
Quick Check
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. If themanager of the division is evaluated based onROI, will she want to make an investment of$100,000 that would generate additional netoperating income of $18,000 per year?
a. Yesb. No
Quick Check
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. If themanager of the division is evaluated based onROI, will she want to make an investment of$100,000 that would generate additional netoperating income of $18,000 per year?
a. Yesb. No ROI = $78,000/$400,000 = 19.5%
This lowers the divisions ROI from
20.0% down to 19.5%.
Quick Check
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The companys required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generateadditional net operating income of $18,000 per
year?
a. Yes
b. No
Quick Check
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The companys required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generateadditional net operating income of $18,000 per
year?
a. Yes
b. No ROI = $18,000/$100,000 = 18%
The return on the investment exceedsthe minimum required rate of return.
Quick Check
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Capital employed
Decision needs to be taken which assets to include in capitalemployed.
Leased assets, shared assets, idle assets and goodwill need tobe given careful considerations.
Centrally controlled assets are excluded because theinvestment center manager cannot exercise control over theiruse
Usually opening capital employed or an average of openingand closing capital is used, on the grounds that this has been
generating the years profit The use of historical cost/carrying amount may lead to
problems
E l Eff t f h i th
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Example: Effect of changing the
capital employed base
An asset costs TK 100,000 has a life of four years, and itsscrap value is nil. The asset generates annual cash flows ofTK 34,000 and straight line depreciation is used
Requirements:(a) Calculate annual ROI using opening carrying amount (i.e.
depreciation is deducted from the asset values)
(b) Calculate annual ROI using historical cost (i.e. nodepreciation is deducted from the asset value)
(c) Comment on any problems identified by these calculations
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Solution
ROI using opening carrying amountYear 1: (34-25) 100 = 9% (cash flow-Depreciation)
Year 2: (34-25) 75 = 12%
Year 3: (34-25) 50 = 18%
Year 4: (34-25) 25 = 36%
ROI improves despite constant annual profits. Consequently divisionalmanagers may hold assets for too long.
ROI using historical costs
Year 1-4: (34-25) 100 = 9%
ROI using historical costs overcomes the increasing return problem of usingthe carrying amount. However, it is not perfect
Li it ti f i hi t i l
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Limitations of using historical
cost/carrying in ROI calculations
Using historical cost/carrying amounts may bemisleading, particularly when comparing divisions. If
Assets have been bought at different points in timeand prices have changed due to inflation
Assets of one division are older than those ofanother and have been written down a lower value
Different depreciation policies are applied by
different divisionsTo resolve this, one solution would be to use a
replacement cost valuation
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Profit
Usually profit figure taken as the numerator in theROI calculation is after depreciation, but this maylead to distortion (as discussed)
It is common for divisions and managers to beassessed on pre-tax profit, since the companysultimate tax charge is likely to be significantlyaffected by central decisions and it therefore notcontrollable by divisional managers
It is important that managers are made aware of thetax implications of their operational decisions
Residual Income Another
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Net operating incomeabove some minimum
return on operatingassets
Residual Income Another
Measure of Performance
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Calculating Residual Income
Residual
income=
Net
operating
income
-
Average
operating
assets
Minimum
required rate of
return( )
This computation differs from ROI.
ROI measures net operating income earned relativeto the investment in average operating assets.
Residual income measures net operatingincome earned less the minimum required
return on average operating assets.
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Residual income encourages managers tomake profitable investments that would
be rejected by managers using ROI.
Motivation and Residual Income
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions residual income?
a. $240,000
b. $ 45,000
c. $ 15,000d. $ 51,000
Quick Check
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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions residual income?
a. $240,000
b. $ 45,000
c. $ 15,000d. $ 51,000
Net operating income $60,000Required return (15% of $300,000) $45,000Residual income $15,000
Quick Check
Divisional Comparisons
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Divisional Comparisons
and Residual Income
The residualincome approach
has one major
disadvantage.
It cannot be usedto compare
performance ofdivisions ofdifferent sizes.
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Zepher, Inc. - Continued
Retail Wholesale
Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%
Minimum required return 20,000$ 200,000$
Retail WholesaleActual income 30,000$ 220,000$
Minimum required return (20,000) (200,000)
Residual income 10,000$ 20,000$
Recall the followinginformation for the RetailDivision of Zepher, Inc.
Assume the followinginformation for the Wholesale
Division of Zepher, Inc.
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Zepher, Inc. - Continued
Retail Wholesale
Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%
Minimum required return 20,000$ 200,000$
Retail WholesaleActual income 30,000$ 220,000$
Minimum required return (20,000) (200,000)
Residual income 10,000$ 20,000$
The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, theRetail Division earned an ROI of 30% compared to an ROI of 22% for the
Wholesale Division. The Wholesale Divisions residual income is larger than the
Retail Division simply because it is a bigger division.
Advantages and disadvantages of
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Advantages and disadvantages of
using RI compared with ROI
Residual income will increase when investmentsearning above the cost of capital are undertaken andinvestments earning below the cost of capital areeliminated
Residual income are more flexible since a differentcost of capital can be applied to investments withdifferent risk characteristics
The disadvantage of RI are that it does not facilitatecomparisons between investments centers nor doesit relate the size of a centers income to the size ofthe investment
RI verses ROI: marginally profitable
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RI verses ROI: marginally profitable
investments
Residual income will increase if a new investment isundertaken which earns a profit excess of the imputedinterest charge on the value of the asset acquired
Residual income will go up even if the profit from the
investment only just exceeds the imputed interest charges,and this means that marginally profitable investments arelikely to be undertaken by the investment center managers
In contrast, when a manager is judged by ROI, a marginally
profitable investment would be less likely to be undertakenbecause it would reduce the average ROI earned by thecenter as a whole