# 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.