Return on Investment and Residual Income

This is a traditional approach to performance measurement given by:

ROI =     Income
         Invested Capital              (method) of Liability analysis

ROI can provide more insight to performance when it is divided into the Dupont components. The Dupont method states that:

ROI = Capital turnover X profit margin
      = (Revenue / Invested capital) X (Income / Revenue)

Dupont method leads to the generalization that ROI can be increased by any action that:

•    Decreases costs
•    Increases revenue
•    Decreases invested capital

Return on investment highlights the benefits that managers can obtain by decreasing investment in both current and fixed assets. Investment in cash, inventory, accounts receivable and fixed assets should be minimized for any level of effective performance. This requires that idle cash is invested, proper inventory levels are kept, credit is managed judiciously and fixed assets are invested in carefully.

However, return on investment may induce managers of a highly profitable division to reject projects, which from the view point of the organization as a whole should be accepted. ROI encourages managers to make decisions which may increase short-term profit without considering their effect on the future of the company.