Question

ROI used to evaluate the performance of an investment center manager can sometimes lead to suboptimization. A performance measure designed to avoid the risk of suboptimization is:

1) operating income.
2) residual income.
3) segment income.
4) the DuPont model.

Answer 1

The performance measure designed to avoid the risk of suboptimization in evaluating the performance of an investment center manager is residual income, which calculates the difference between a manager's actual income and their required income based on their investment. So the correct answer is option 2.

Step-by-step explanation:

The performance measure designed to avoid the risk of suboptimization in evaluating the performance of an investment center manager is residual income. Residual income is a performance measure that calculates the difference between a manager's actual income and their required income based on their investment.

It takes into account the opportunity cost of using the investment elsewhere and incentivizes managers to make decisions that maximize the overall profitability of the organization. Unlike ROI, which can lead to suboptimization as it focuses solely on the return on investment percentage, residual income considers both the return and the investment, providing a more comprehensive measure of performance.

To address the student's question about which performance measure is designed to avoid the risk of suboptimization: residual income is the correct choice. Suboptimization can occur when a manager, who is evaluated based on Return on Investment (ROI), may reject profitable projects if those projects lower the center's overall ROI.