Final answer:
Residual income is a better measure for performance than ROI because it considers the cost of capital and provides a more accurate assessment of profitability. It takes into account the income remaining after deducting the cost of capital from the net operating profit, allowing companies to evaluate the profitability of an investment after accounting for the resources used.
Step-by-step explanation:
Residual income is a better measure for performance than Return on Investment (ROI) because it takes into account the cost of capital and provides a more accurate assessment of profitability. ROI only considers the financial return generated by a particular investment, while residual income measures the income remaining after deducting the cost of capital from the net operating profit. This allows companies to evaluate the profitability of an investment after accounting for the resources used to generate that income.
For example, let's say Company A and Company B both have an ROI of 10%. However, Company A generated higher residual income than Company B because it had a lower cost of capital. This indicates that Company A was able to generate more income with fewer resources, demonstrating better performance.
In today's dynamic business environment, where companies need to optimize their use of resources, residual income provides a more comprehensive measure of performance compared to ROI. It considers both the financial return and the efficiency of resource utilization, making it a valuable metric for assessing the profitability and effectiveness of investments.