This video discusses the difference between ROI and Residual Income.
Both ROI and Residual Income are metrics frequently used to evaluate a division’s profitability. However, ROI is expressed as a percentage whereas Residual Income is expressed as a unit of currency (e.g., dollars). This makes ROI more attractive because it is easier for managers to understand a percentage.
However, ROI has a significant disadvantage relative to Residual Income. ROI may lead to suboptimal decisions if a divisional manager rejects a project that would increase the value of the overall firm but would decrease the division’s ROI. For example, if the division’s ROI is currently 32%, the divisional manager might reject a project that has an ROI of 27% because it would reduce the ROI of the division (even though it might benefit the company as a whole). The use of Residual Income does not lead to this problem; when divisional managers are evaluated based on Residual Income, they have an incentive to accept any projects that earn a return higher than the amount the division is being charged for its capital.