Section A

A heavy mining corporation evaluates its divisional managers using Return on Investment (ROI). The board is considering switching to Residual Income (RI).

What is the primary advantage of using RI instead of ROI for divisional performance measurement?

A major flaw of ROI is dysfunctional behavior: a manager with a high current ROI might reject a new project that exceeds the company's cost of capital but is lower than their current ROI, because it would drag their average down. Residual Income (RI) solves this. Since RI is an absolute measure (Profit - Imputed Interest), any project returning more than the cost of capital will increase total RI, encouraging managers to accept it.