PERFORMANCE MANAGEMENT
When Higher ROI Isn’t Better
Understanding Residual Income, Goal Congruence and Value Creation
In the 1920s, DuPont pioneered an idea that seems obvious today but was revolutionary at the time: when judging the performance of an investment centre, managers should weigh not just the income it generates, but the capital required to generate it.
Before that, firms often ranked divisions on absolute profit alone. If Division X made CAD 1 million and Division Y made CAD 0.8 million, X looked like the stronger performer. But look behind the numbers. If X invested CAD 10 million to earn that CAD 1 million, its return is 10%. If Y invested only CAD 5 million to earn CAD 0.8 million, its return is 16%. Despite the smaller profit, Y is generating far more value per dollar invested.
That insight gave rise to Return on Investment (ROI), still one of the most widely used measures of divisional performance. It marked a genuine shift in management thinking: performance could no longer be judged by the size of a division’s profit alone but had to be weighed against the capital tied up in producing it. That shift still underpins how most firms evaluate business units today.
Understanding ROI
ROI expresses divisional profit as a percentage of the assets employed:
ROI = Divisional Profit ÷ Investment in the Division × 100
“Assets employed” can mean total divisional assets, assets controllable by the divisional manager, or net assets (assets less relevant liabilities), depending on the firm. Whatever the definition, the principle is the same: express return as a percentage of capital employed.
ROI’s popularity is easy to explain. It is simple to understand and calculate, draws on readily available accounting data, allows quick comparison across divisions, and is familiar to shareholders through its resemblance to measures like return on equity. Senior management can see briefly which division is performing best.
On the surface, it looks like the ideal measure. There is, however, a significant catch.
The Goal Congruence Problem
ROI’s central flaw is that a decision which raises a division’s ROI can lower the firm’s overall ROI and vice versa. This is a failure of goal congruence: what benefits the division should also benefit the firm.
Consider a division earning a 15% ROI that is offered a new project expected to return 12%. Accepting it would drag down the division’s average, so a manager evaluated purely on ROI may reject it. But if the firm’s cost of capital is only 8%, that 12% project still creates value four points above the required return. A manager focused on protecting divisional ROI may turn away a project that the firm should clearly accept. The division wins; the firm loses. This is classic sub-optimisation.
Distortion from Accounting Policy
ROI is also vulnerable to distortion from the accounting policies behind it. Different depreciation methods (straight-line versus written-down-value), different inventory valuation approaches (FIFO versus weighted average), and different treatment of R&D costs (capitalised versus expensed) can all produce different ROI figures for divisions that are, economically, performing identically. The number can move even when underlying performance has not a reminder that ROI should never be read in isolation, and does not always track wealth creation closely.
There is a further, more subtle distortion. Older assets that have been substantially depreciated carry a lower net book value, which mechanically inflates ROI even if the equipment is inefficient and overdue for replacement. A manager nearing the end of a bonus period may therefore be tempted to defer capital investment simply to protect a favourable ROI, at the expense of the division’s longer-term competitiveness. This is another way in which an accounting ratio, taken at face value, can quietly work against the firm’s real interests.
Enter Residual Income
Residual Income (RI) was developed to address ROI’s dysfunctional incentives. RI is the excess of controllable profit over a firm-wide required return, a capital charge on the investment the manager controls:
Residual Income = Controllable Profit − Capital Charge, where Capital Charge = Cost of Capital × Investment
Take a division with CAD 10 million invested and an 8% cost of capital: the capital charge is CAD 0.8 million. If the division earns CAD 1.2 million in controllable profit, its RI is CAD 0.4 million value generated above the minimum the firm requires.
Where ROI asks, “what percentage did the division earn?”, RI asks, “how many dollars did it earn above the minimum required return?” That distinction matters enormously for decision-making.
Why RI Improves Alignment
Under RI, a manager has every incentive to accept the 12%-return project in the earlier example, because it still adds to RI even though it would have diluted ROI. The same self-interest that drives dysfunctional behaviour under ROI works in the firm’s favour under RI, because maximising RI means accepting any project that clears the firm’s required rate of return.
RI’s Own Limitation
RI is not without drawbacks. As an absolute, dollar-based measure, it is a poor tool for comparing divisions of very different sizes. A division with CAD 2 million of RI looks stronger than one with CAD 1 million until you learn the first has CAD 20 million invested and the second only CAD 5 million. Larger divisions naturally generate more residual income simply by virtue of their size. And like ROI, RI still rests on accounting figures, so it remains exposed to the same policy-driven distortions.
Which Measure Should Firms Use?
There is no universal answer. Where goal congruence is the priority encouraging managers to accept every value-creating project RI is generally the better tool. Where the priority is straightforward comparison, particularly among similarly sized divisions, ROI’s simplicity and familiarity remain valuable, provided management stays alert to the risk of sub-optimisation.
In practice, most firms need not choose. ROI works well for divisional comparison, performance communication, trend analysis and benchmarking. RI is better suited to assessing value creation, evaluating investment decisions, encouraging goal congruence, and calculating bonuses and incentives. Used together, the two give management a far more balanced view of divisional performance than either could alone.
Some organisations go a step further and blend the two directly into incentive design for example, using RI as the primary driver of bonus calculations while still reporting ROI alongside it for comparability and external communication. Others supplement both with non-financial indicators, such as customer satisfaction or employee retention, recognising that no single accounting ratio, however carefully constructed, can fully capture a division’s contribution to long-term value.
The Bigger Lesson
The real debate is not which formula is superior it is what behaviour a performance measure encourages. A good measure does more than report what happened; it should push managers toward decisions that serve the firm. ROI is simple and familiar but can tempt managers to defend their percentage return at the expense of value-creating opportunities. RI corrects for this by rewarding absolute value creation above the required return, at the cost of being less suited to comparing divisions of different sizes.
The lesson for any organisation designing its performance framework is the same: it is not enough to measure performance the goal is to measure the right performance, in a way that keeps managerial incentives pointed at long-term value for the firm and its shareholders.
“A better percentage does not always mean a better performance.”