Question

A key limitation of residual income (RI) as a measure of divisional financial performance is that RI ______.

Option 1: Encourages short-term decision-making.
Option 2: Ignores the cost of capital.
Option 3: Requires complex calculations.
Option 4: Favors larger business units.

Answer 1

Residual income (RI) favors larger business units, which is a key limitation of using RI as a measure of divisional financial performance.

Step-by-step explanation:

A key limitation of residual income (RI) as a measure of divisional financial performance is that RI favors larger business units. Option 4 is the correct answer. Residual income is calculated by subtracting the cost of capital from the operating income. Therefore, divisions with larger investments can sometimes be favored because they are more likely to generate a significant absolute amount of residual income compared to smaller divisions, even if the percentage return is the same. This does not necessarily reflect efficiency or profitability relative to the size of the division.