Limitations, Criticism or Disadvantage of Residual Income Method


Limitations, Criticism or Disadvantage of Residual Income Method:

The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.

You would expect larger divisions to have more residual income than smaller divisions, not necessarily because they are better managed but simply because they are bigger.

Example:

As an example consider the following residual income computations for division X and division Y.

Average operating assets (a)

Net operating income
Minimum required return: 10 × (a)

Residual income

Division X$1,000,000
========
$120,000
$100,000
————-
20,000
=======
Division Y$2500,000
========
$40,000
$25,000
————-
15,000
=======

Observe that division X has slightly more residual income than division Y, but that division X has $1000,000 in operating assets as compared to only $250,000 in operating assets for division Y. Thus, division X’s greater residual income is probably more  a result of its size than the quality of its management. In fact, it appears, that the smaller division is better managed, since it has been able to generate nearly as much residual income with only one fourth as much much in operating assets to work with. This problem can be reduced by focusing on the percentage change in residual income from year to year rather than on the absolute amount of the residual income.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

  1. Decentralization in organizations
  2. Traceable and common fixed costs
  3. Segment reporting and profitability analysis-segmented income statements
  4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
  5. Segmented Financial Information on External Reports
  6. Return on Investment (ROI) for Measuring Managerial Performance
  7. Controlling and Improving Rate of Return on Investment
  8. Return on Investment (ROI) and Balanced Scorecard
  9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
  10. Residual Income-Another Method to Measure Managerial Performance
  11. Limitations, Criticism or Disadvantage of Residual Income Method
  12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  13. Set transfer prices at cost using variable or full (absorption) cost
  14. Set transfer prices at the market price
  15. Divisional Autonomy and Sub optimization
  16. International Aspects of Transfer Pricing

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