Investment Centre Performance Management - Residual Income

Residual Income (RI) Overview

  • RI is the net operating income above the minimum required return on operating assets.

  • RI Calculation: RI=Net Operating Income−Minimum Required Return\text{RI} = \text{Net Operating Income} - \text{Minimum Required Return}

  • Example: Lethbridge Division

    • Average Operating Assets: 100,000100,000

    • Net Operating Income: 20,00020,000

    • Minimum Required Rate of Return: 15%15\%

    • Minimum Return: 15,00015,000

    • Residual Income: 5,0005,000

Advantages of Residual Income vs ROI

  • Encourages managers to make profitable investments that may reduce ROI.

  • Example: Investment in diagnostic machine generating 4,5004,500 additional income (cost: 25,00025,000)

    • RI Evaluation: Positive effect on overall RI.

    • ROI Evaluation: Decreases ROI from 20%20\% to 19.6%19.6\%.

  • Managers evaluated on RI make better investment decisions aligned with company interests.

Performance Issues in Residual Income

  • Cannot directly compare performance across different-sized divisions due to inherent biases in size.

  • Example: Division X vs. Division Y, where size discrepancies influence RI despite performance quality.

  • Suggestion: Focus on year-over-year percentage changes in RI for better comparative insights.

Transfer Pricing Concepts

  • Necessary for internal sales between segments classified as profit centers (e.g., IT Department).

  • Transfer Pricing: Predetermined price for internal services.

  • Three Methods to Determine Transfer Price:

    1. Market-based price

    2. Cost-based price

    3. Negotiated price

  • Objectives: Ensure segment managers act in the organization's best interests while maintaining segment profitability.