Residual income measures the excess of the income earned over the desired income. The desired income is based on a minimum required rate of return. Unlike the return on investment (ROI) that computes for a percentage or rate, the residual income (RI) computes for an absolute dollar value.
Unlike the return on investment (ROI) that computes for a percentage or rate, the residual income (RI) computes for an absolute dollar value.
The formula in computing for the residual income is:
| RI | = | Operating income - Desired income |
in most cases:
Desired income = Minimum required rate of return x Operating assets
Note: Usually, the minimum required rate of return is equal to the cost of capital. The average of the operating assets is used when possible.
Compute for the residual income of an investment center which had operating income of $500,000 and operating assets of $2,500,000. The cost of capital is 12%.
| Desired income | = | Minimum required rate of return x Operating assets |
| = | 12% x $2,500,000 | |
| Desired income | = | $300,000 |
| RI | = | Operating income - Desired income |
| = | $500,000 - $300,000 | |
| RI | = | $200,000 |
The investment made $200,000 above its desired or minimum income.
The calculation of residual income results in a dollar value. A positive amount indicates that the subunit or investment was able to generate more than its minimum or desired income. The higher the residual income, the better.
The major disadvantage, however, of residual income is that it cannot be used in evaluating investments of different sizes. The results would favor bigger investments because of the larger dollar amounts involved.
Residual income is calculated as operating income minus desired income or minimum income required.
Generally, an investment is acceptable if the residual income is positive. It means that actual or potential return exceed the minimum return required. This minimum requirement is usually equal to the cost of the investment.
