In this article, we will cover how to calculate the residual income in management accounting or performance management. Before jumping into detail, let’s understand some overview as well as some key definitions of the residual income.
Management of a company appraises the income yielded after paying all the relevant costs of capital in order to evaluate the company’s performance in management accounting for which it uses residual income concept. In personal finance the same concept is also used to know income received after the work has been completed, or as the income left over after paying all personal debts and obligations.
What is Residual Income?
Residual income has been given definition in different ways. In general term, residual income is the income which is earned and received after the completion of the all the work which was the source of producing that income. Examples include income from the ongoing sale of consumer goods, royalties, interest and dividend income, and rental/real estate income.
In specific term, the residual income has been given definition based on the context as below:
Residual Income in Management Accounting
In management accounting or performance management, residual income is a measure of investment or profit centers after deducting the imputed or notional interest cost of capital on net assets. We commonly use it as a divisional performance measures of projects, departments or portfolios.
Imputed or notional interest cost here refers to cost of investment of net assets.
Residual Income in Personal Finance
In personal finance, residual income is also known as passive income or disposable income. It is the income after all monthly debts have been paid. This residual income is commonly used as the basis in order to obtain a loan from bank. Typically, bank looks at residual income of a person for their assessment to see the ability of repayment if the loan is granted.
Discretionary income term is also used for residual income in the context of personal finance. This means any excess income that an individual possesses after paying all outstanding debts, such as car loans, mortgages etc.
This can be better understood by an example, Let’s say an individual earns a salary of $10,000 but also pays monthly mortgage payments and car loans of $1,800 and $2,700 respectively. His residual income would be $5,500 [$10,000 – ($1,800 + $2,700)]. So it can be said that the amount of money that is left over after making the necessary payments is $5,500 which is the residual income of this individual.
Why Residual income is also known as passive income?
Let’s understand this with an example of Bill Gates who continues to receive money from Microsoft although he has left the company and isn’t in the company anymore. Even a CEO of a company who is about to quit his job also receives residual income by just giving advice to the new upcoming CEO. Accountants call this income a passive income because there is no job active but you receive this income. It is pertinent to mention here that for a residual income; you must also have some source of active income otherwise the income a person is receiving will not be termed as residual income.
In the later section below, we will focus on the residual income in management accounting or performance management.
How to calculate Residual Income?
In management accounting, the residual income can be calculated by deducting the controllable profit by imputed interest charged on net assets or capital employed.
The residual income formula is as follow:
Residual income = Controllable Profit– Imputed Interest Charge on Net Assets
Imputed Interest Charged on Net Assets = Net Assets (Capital Employed) x Cost of Capital
- Controllable profit is the profit before the apportion of head office cost of a divisional projects or investment centres
- Cost of Capital is the required rate of return which is the minimum amount of return that a company is willing to accept from the amount invested.
In management accounting or performance management, responsibility accounting is very important. This is because we need to truly evaluate the performance of investment center or profit center, we commonly use the operating profit. This profit is before accounting for the head office cost allocation. This way, any non-controllable factors are ignored as it is beyond control of department or center manager. This operating profit is called controllable profit of the department, segment or profit center.
In addition, in a more advance approach, especially for equity valuation, we use the net income and adjust some costs to arrive at the economic profit. This is commonly call Economic Value Added (EVA). For purpose of this article, we will not cover the EVA.
Example and Analysis
ABC Co has two divisions, division M and N. Division M is a manufacturing division selling computer equipment. Division N is a service division. Below is the extracted data for both divisions:
|Division M US$ million||Division N US$ million|
|Apportion head office costs||80||1|
|Profit before tax||320||4|
The notional cost of capital is 10% pa.
Calculate the residual income of both division.
We can calculate the residual income of both divisions by using the below formula:
Residual Income = Controllable Profit – Imputed Interest Charge on Net Assets.
Controllable profit is the operating profit of each division
Net assets is the capital employed of each division
Thus, the residual income is as follow;
Residual Income (M) = 400 – 1,200 × 9% = US$292 millions
Residual Income (N) = 5 – 30 × 9% = US$2.3 millions
From the calculation above, both divisions give positive residual income. This means that both division provide a fruitful return.
When Should We Use RI as a Performance Measure?
The concept of Residual income is used when a company is about to make a decision regarding whether or not to accept a project or whether a division of a company will be able to generate in excess of the goal of minimum return as set by a company.
Usually every company sets a minimum required rate of return for the acceptance or rejection of projects or investments which is mainly in percentage that at least must be achieved in order for the company to make a decision regarding its acceptance. Companies usually do this because it acts as an evaluation tool. This return is utilized as a basis for assessing investments so that the company may meet its goals and objectives, and to make sure that only profitable projects will be accepted.
The company will accept a project whose residual income is a positive number, because it shows that the project is earning more than the minimum as expected by the company. There is another measuring tool for the assessment i-e Return on investment (ROI). Both ROI and RI are practicable but both tools have some limitations. Therefore, companies have to use ROI and RI in combination while making assessments, evaluating performance and before making any decision.
Advantages of Residual Income
- Traditionally prepared income statement shows the earnings that owners or the shareholders of a company have available to them. Hence this statement calculates net profit after taking into account an interest expense for the debt cost of capital. And no deduction for dividends or any other charges for the equity capital is considered while preparing the income statement. So, it can be said that it is up to the owners or shareholders to conclude whether their funds are earning in an economic way under these conditions or not.
- However, on the other side, the residual income accounts for shareholder’s opportunity cost and therefore subtracts the estimated cost of equity capital while calculating the residual income. Since cost of equity represents an additional cost of equity (by selling more interests of equity or internally generated) so it can also be termed as marginal cost of equity. During valuation, this residual concept is majorly used.
- Another advantage of this concept is when used in comparison with return on investment (ROI) as it recommends investment center managers to make new investments if they add value to residual income. This usually happens that a new investment adds to RI but in actual it reduces ROI. Measuring of performance by RI in such situation would not result in dysfunctional behavior, i.e. the best decision will be taken by considering the business as a whole and not for a specific part of business.
- Residual Income approach provides an absolute figure for income generated for each division. Thus, it is easy to understand as if the residual income is positive, that means it is good.
Limitation of Residual Income
One major drawback this residual income approach has is that it cannot be used for comparability purposes while evaluating the performance of divisions of different sizes.
You might anticipate more residual income from a division which is larger in size than smaller divisions simply because they are bigger in size and not need fully because they are better handled.
From the above example, it can be easily observed that division M has somewhat more residual income than division N, but it must be noticed that division M has US$320 million in capital employed as compared to US$30 million in capital employed for division N. Therefore, it can be said that the reason behind division M’s greater residual income is likely due to its size than the quality of its management. If the situation is critically analyzed it can be easily noted that the smaller division is managed in a better way because it was able to yield nearly as much residual income with just only one fourth as much in operating assets as compared to the operating assets of a division which is quite larger in size. However, this limitation can be handled by concentrating on the year to year percentage change in residual income rather than on the absolute amount of the residual income.
Another limitation is that residual income is a profit based measures. It take the controllable profit as the basis and then take out the imputed interest charge on net assets. This profit is unclear how to measure the shareholder return. The shareholder return usually depends on share price and dividends paid rather than just profit. Thus, EVA is more suitable as it is not just used the accounting profit but it considers more on economic profit by making further adjustment.
The concept of residual income is very significant both in personal life as well as in the field of finance. The concept is used as a measuring tool since it helps in making assessments and evaluations and assists in making the decision. However, its limitations can also not be ignored during the application of this concept.