This document discusses residual income as a performance measure for investment centers. It defines an investment center as a business unit responsible for its own revenue, expenses, and assets. Performance can be measured financially through return on investment and residual income. Residual income is defined as net income exceeding the minimum desired rate of return on invested capital. The document also compares residual income to other measures like ROI and EVA. Logistic companies are given as an example where residual income is useful, and Amazon is discussed as a company that uses residual cash earnings to evaluate performance and correlate it with total shareholder return.
2. Investment Center
In a decentralized structure where the daily operations
and decision-making responsibilities are delegated by
top-level management to middle and low-level managers,
the concept of Responsibility Center arises and there are
4 types:
revenue center, cost center, profit center, investment center
An investment center is a business unit within an entity
that has responsibility for its own revenue, expenses,
and assets. An investment center typically has its
own financial statements, comprised of at least
an income statement and balance sheet. Management
evaluates an investment center based on its return on
those assets (and offsetting liabilities) invested
specifically in the investment center.
3. Performance Measures
Performance Measures generally means measuring the
performance of the organization on the basis of various
factors.
For investment centers there are generally two types of
performance measurements, non-financial measures and
financial measures.
Non-financial measures are referred to market measures
Financial measures are referred to accounting measures. Again
accounting measures can be divided into two categories
return on investment
residual income.
Other than traditional residual income measures, an important
extension form of residual income method is economic value added
method.
4. Residual Income
Residual income is the amount of net income generated
in excess of the minimum rate of return. The
measurement of internal corporate performance whereby
a company's management team evaluates the return
generated relative to the company's minimum required
return.
RI = Actual income- Desired income
Where, Desired income = desired rate of return x
Invested capital
And, desired rate of return is the minimum rate of
return an investor feels should be earned in
compensation for the amount of risk assumed.
5. ROI vs RI
Under ROI the basic objective is to maximize the rate
of return percentage.
ROI= NOI/Av op Asset
It gives co. a means of compare the effectiveness and
profitability of any number of investments
On the other hand, under RI the manager would be
inclined to invest in the projects earn more than the
desired rate of return.
Residual income is considered a better overall
performance measure as it is an absolute measure.
6. EVA vs RI
Both are methods businesses can use to evaluate
investment opportunities and EVA evaluates how
much money in excess of the business' cost of capital
the investment is projected to generate. The
difference between the two methods is in how each
calculates the investment's projected revenues.
EVA is the more complicated calculation, as it makes
more adjustments to the accounting measures of the
investment.
EVA=adjusted net operating profits after taxes –
(cost of capital * adjusted assets employed)
7. Case Study
Logistic Industry (Logistic Performance measurement-
issues and reviews, Academia.edu)
Logistics is a backbone for the global supply chains and it
offers services that could fulfil customer’s needs,
influences on customer retention rate, product delivery,
and many other core business processes.
The relevance of performance measures in logistic
industry as it can enhance the value chain of the
company from the process of production to the end of
delivery of the products by identifying value-added
activities
8. Cont..
Basically four views are taken into consideration in order to
choose a performance measurement and are Goal
congruence, Reinforcing company’s strategy, Quantifiable
and controllable
Source : Academia.edu
9. Amazon
Amazon is the largest internet-based retailer in the
United States.
It is selling electronic products, books and nowadays,
even food and clothes online.
In order to make sure that its delivery is efficient and
on time, Amazon keeps improving its logistic chain.
Today, Amazon logistics is not only just logistics
department for delivering products of Amazon, it is
also a more independent business unit in logistic
industry, which offers delivery services for other
companies as well.
10. RI in Amazon
The Residual Cash Earnings (RCE) where measure is
calculated as the cash generated by the business less
a charge (equity charge) that reflects the expected
return of the shareholders and lenders for the use of
the company’s capital plays an important role
the change in RCE, as a percent of beginning gross
operating assets, correlates with Total Shareholder
Return (TSR) better than any other measure
The improvement in RCE captures growth,
profitability and asset efficiency (including R&D
efficiency)
11. Conclusion
There are 2 type of performance measure: market
and accounting measure. Accounting measures
comprises with ROI, RI and EVA. In logistic
industry, as the paper suggested is where RI is useful
for evaluating performance. Then with the example
of a common logistic company i.e. Amazon it is seen
how RCE is beneficial for TSR.
