Residual Income : Definition And How Its Work

Residual income, often used in financial activities in a business

Understanding the residual income itself is the operating profit (operating income) that can be generated an investment center on the return (minimum) assets.

Then, how is the residual income formula itself and how to calculate it?

Residual income = net operating income - (minimum income level of investment x total operational asset)

The minimum rate of return is often based on the weighted-average cost of capital of a company.

Example. Assume that a company's operating asset is $ 100,000,000, net income of $ 18,000,000, and a minimum return on asset is 13%. Thus, residual income is:

Net operating income = $ 18,000,000
Less: minimum return x total operational assets: 13% x $ 100,000,000 = $ 13,000,000
Residue Profit: $ 5,000,000


Who uses it and How?

Finance Manager. Residual income is the absolute amount of profit and not a rate of return and is used to evaluate the performance of each division.

Evaluation based on residual income encourages managers to dare to accept investment opportunities that have a rate of return higher than the cost of capital invested.
Managers evaluated using return on investment (ROI) may be reluctant to accept new investments that will lower their current ROI, even if the investment will benefit the company as a whole.

The advantages of using residual income in evaluating the performance of each division include the following:

Residual income is an economic profit that takes into account the minimum income that an asset must earn.
The minimum rate of return may vary depending on the risk level of a division.
Different assets may be required to obtain different returns depending on the risks.
The same asset may be required to obtain the same return regardless of what division the asset is in.
The impact of maximizing the dollar rather than maximizing the percentage will lead to the harmony of goal attainment.
The main disadvantage of residual income is that it cannot be used to compare divisions of different sizes. Residual income tends to favor larger divisions because it involves a larger dollar amount.

Financial Analyst. Investment and financial analysts view a higher positive residual income because it means the company not only gains a net income but also succeeds in closing the opportunity costs that arise from tying assets in a business.

The higher the residual income ratio over net income, the better the quality of income. Residual income is seen by many analysts as a measure of real profit better than net income.

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