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Performance Management · Performance analysis

Return on Investment and Residual Income for ACCA PM

Updated 11 October 2026 · Fact-checked

ROI is divisional profit as a percentage of capital employed. Residual income (RI) is divisional profit minus an imputed interest charge, which is capital employed × the cost of capital. Compare ROI with the target return, or accept any project with positive RI. RI better supports decisions that add value to the whole company.

Understand Return on Investment and Residual Income

A company with several divisions needs a way to judge each divisional manager. Profit alone is not enough. A large division will usually earn more profit than a small one. So you need to relate profit to the capital the division uses.

Return on investment (ROI) does this with a percentage. It is divisional profit divided by capital employed. A higher ROI means more profit for each unit of capital. You can compare divisions of different sizes, and you can compare a division with its target or with outside firms.

Residual income (RI) gives an absolute amount. You take divisional profit and deduct an imputed interest charge. This charge is capital employed multiplied by the company's required rate of return, normally the cost of capital. It is imputed because no cash is paid. It shows what the capital should earn. A positive RI means the division earns more than the required return.

The two measures can lead to different decisions. ROI can make a manager reject a project that earns more than the cost of capital, because it would pull down the division's average ROI. RI avoids this, because any project earning above the cost of capital increases RI. This is why RI is generally seen as more consistent with the goals of the whole company (goal congruence).

Both measures depend on how profit and capital employed are defined. Depreciation, asset age, leases, and non-controllable costs all change the answer. Both are also short-term, financial measures. They can push managers to cut R&D or delay replacing assets.

Key rules to remember

Return on investment (ROI)
ROI = Divisional profit ÷ Capital employed × 100%
Profit is usually controllable profit before interest and tax. Capital employed is usually total assets less current liabilities, or the net asset base for the division. Use the definition the question gives.
Imputed interest charge
Imputed interest = Capital employed × Cost of capital (required return)
A notional charge, not a cash cost. Use the same capital employed figure as in ROI.
Residual income (RI)
RI = Divisional profit − Imputed interest charge
Result in money terms. Positive RI means the division earns more than the required return.
ROI decision rule
Accept a project if its ROI ≥ the division's target ROI
Managers often compare with the division's current ROI instead. This is the source of the goal congruence problem.
RI decision rule
Accept a project if it increases RI, that is if project profit > capital invested × cost of capital
Equivalent to the project's return exceeding the cost of capital.

How to solve Return on Investment and Residual Income questions

Use this order for any ROI or RI question, including ones that ask whether a manager would accept a project.

  1. 1Read the question for the exact profit and capital employed definitions. Note whether profit is before or after depreciation, interest and tax, and whether any non-controllable costs must be excluded.
  2. 2Work out the capital employed. If the question gives opening and closing figures, check whether it asks for the year-end or the average.
  3. 3Calculate ROI: profit ÷ capital employed × 100%.
  4. 4Calculate the imputed interest charge: capital employed × cost of capital.
  5. 5Calculate RI: profit − imputed interest. Keep the sign. A negative RI is a valid answer.
  6. 6If a project is involved, recalculate with the project's profit and capital added. Compare the new ROI or RI with the old one and with the target.
  7. 7State the decision and who it favours: the manager (using ROI or RI) and the company (return above cost of capital).
  8. 8If asked to comment, add the key limits: short-term focus, asset age and depreciation, and different definitions of profit and capital.

Quickest way: Compare project return with the hurdle

When to use it: Use this in a Section A or OT case question asking whether a manager would accept a project, when you do not need the full divisional figures.

  1. Find the project's profit and capital invested.
  2. Project ROI = project profit ÷ capital invested. Compare it with the division's current ROI (manager's view under ROI) and with the cost of capital (company's view).
  3. For RI, calculate project profit − (capital invested × cost of capital). If positive, RI rises and the project is accepted.
  4. If the project ROI is between the cost of capital and the current ROI, expect the ROI manager to reject and the RI manager to accept.

Common mistakes in Return on Investment and Residual Income

  • Treating the imputed interest charge as a cash cost or including actual interest paid as well

    The word interest suggests a real payment.

    Fix: Use the charge only as a notional deduction in RI. If profit is stated before interest, do not deduct actual interest again.

  • Using the wrong capital employed figure, such as opening instead of closing or average

    Students rush and take the first capital figure in the question.

    Fix: Check the wording. Use exactly the base the question states, and use the same base for ROI and the interest charge.

  • Writing RI as a percentage

    It is confused with ROI.

    Fix: RI is a money amount. ROI is a percentage. Label your answer with a currency sign.

  • Saying a project is accepted under ROI because its return exceeds the cost of capital

    Students mix up the company's view with the manager's rule.

    Fix: Under ROI, the manager compares the project with the division's current or target ROI. Under RI, the comparison is with the cost of capital.

  • Forgetting to reduce profit and capital employed for non-controllable items

    The question asks about the manager's performance, but the student uses total division profit.

    Fix: If asked about manager performance, use controllable profit only. Division performance as an investment can use profit after allocated costs.

  • Giving a one-sided evaluation, for example only listing advantages of RI

    Students memorise a list without linking it to the scenario.

    Fix: Give a balanced view: RI aligns better with company goals but cannot compare divisions of different size directly. ROI allows comparison but can discourage good projects. Both are short-term and depend on how assets are valued.

Worked examples

Example 1

Division A has profit of $240,000 and capital employed of $1,200,000. The company's cost of capital is 15%. Calculate the ROI and residual income.

Show the solution
  1. ROI = 240,000 ÷ 1,200,000 × 100% = 20%.
  2. Imputed interest = 1,200,000 × 15% = $180,000.
  3. RI = 240,000 − 180,000 = $60,000.

Answer: ROI is 20% and residual income is $60,000.

Example 2

Division B has profit of $300,000 and capital employed of $1,500,000. The cost of capital is 12%. A new project needs $400,000 of capital and will earn annual profit of $60,000. Would the divisional manager accept the project if judged on (a) ROI and (b) RI?

Show the solution
  1. Current ROI = 300,000 ÷ 1,500,000 = 20%.
  2. Project ROI = 60,000 ÷ 400,000 = 15%.
  3. (a) Under ROI, the project's 15% is below the current 20%. It would lower the division's ROI to 360,000 ÷ 1,900,000 = 18.9%, so the manager rejects it.
  4. Imputed interest on the project = 400,000 × 12% = $48,000.
  5. (b) Project RI = 60,000 − 48,000 = $12,000. This is positive, so divisional RI rises and the manager accepts it.
  6. From the company's view, 15% exceeds the 12% cost of capital, so the project should go ahead.

Answer: Under ROI the manager rejects the project, because new divisional ROI would be 18.9% against 20% now. Under RI the manager accepts it, because it adds $12,000 of RI. The company should accept it, so RI gives better goal congruence.

Exam tips

  • Show the imputed interest line separately. Method marks are often given for it even if the final RI is wrong.
  • In written parts, tie your comment to the scenario. Say which manager would reject which project and why.
  • If the question tells you the capital employed definition, follow it exactly, even if it differs from the textbook.
  • When asked to compare divisions, point out that RI favours larger divisions and ROI favours smaller ones. Use ROI for comparison across size.
  • Always give the units: % for ROI, currency for RI.

Practice questions from Performance analysis

Return on Investment and Residual Income in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Return on Investment and Residual Income: frequently asked questions

What is the main difference between ROI and residual income?

ROI is a percentage: profit divided by capital employed. Residual income is a money amount: profit minus a charge for the capital used. RI is more likely to lead managers to accept projects that benefit the company.

What is the imputed interest charge in residual income?

It is a notional charge equal to capital employed multiplied by the required rate of return, usually the cost of capital. No cash is paid. It represents the return the capital should earn.

Why can ROI lead to bad investment decisions?

A manager with a high ROI may reject a project that earns less than the current ROI but more than the cost of capital. Accepting it would add value to the company but reduce the divisional ROI.

Can residual income be negative?

Yes. If divisional profit is less than the imputed interest charge, RI is negative. This means the division earns less than the required return on its capital.