Final answer:
Residual income is a better measure for performance evaluation of an investment center manager than return on investment because of limited problems associated with measuring the asset base, lack of rejection of desirable investments, and the focus on gross book value of assets rather than returns.
Step-by-step explanation:
Residual income is a better measure for performance evaluation of an investment center manager than return on investment because:
- The problems associated with measuring the asset base are limited
- Desirable investment decisions will not be rejected by divisions that already have a high ROI
- Only the gross book value of assets needs to be calculated
- Returns do not increase as assets are depreciated
Return on investment (ROI) is a commonly used measure to evaluate the performance of investment center managers. However, it has limitations that make residual income a better measure in certain cases.
Firstly, ROI is calculated by dividing the net income generated by an investment center by its average operating assets. The measurement of the asset base can be challenging, especially when there are many intangible assets or assets with fluctuating values. This can lead to inaccuracies in calculating ROI and make it an unreliable measure for performance evaluation.
Secondly, ROI doesn't consider the specific investment opportunities available to a division. Divisions with high ROI may reject desirable investment opportunities that would lead to further growth and higher profits because it may lower their overall ROI. This can result in missed opportunities for the organization as a whole. Residual income, on the other hand, considers the absolute amount of income generated by a division, which encourages divisions to pursue profitable investment opportunities regardless of their impact on ROI.
Thirdly, ROI is based on the average operating assets, which includes both the gross book value and the accumulated depreciation of assets. As assets are depreciated over time, the ROI may increase even if the income generated remains the same or decreases. This can create a misleading picture of the division's performance. Residual income, on the other hand, only considers the gross book value of assets, providing a more accurate measure of the income generated relative to the assets employed.