What is Residual Income?

Residual Income is the dollar amount of division operating profit in excess of the division’s cost of acquiring capital to purchase operating assets. 

The calculation is as follows:

Residual income = Operating income − (Percent cost of capital × Average operating assets)

How to Use Residual Income to Evaluate Performance? 

Rather than using a ratio to evaluate performance, RI uses a dollar amount. 

As long as an investment yields operating profit higher than the division’s cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. 

The manager’s goal is to increase Residual Income from one period to the next.

Notice that operating income and average operating assets used here to calculate RI are the same measures used in the ROI calculation presented earlier. 

The one new item, percent cost of capital, is the company’s percentage cost to obtain investment funds (often called capital). 

For example, a company that raises funds by issuing bonds would use the interest rate associated with the bonds in establishing its percent cost of capital. 

Three RI calculations are provided as follows, 

• (1) RI before the new investment, 
• (2) RI from the new investment, and 
• (3) RI after the new investment. 

(Note: Some organizations make adjustments to the cost of capital to determine the minimum required rate of return. Throughout this chapter, assume percent cost of capital is the same as minimum required rate of return unless stated otherwise.)  

Using RI as a performance measure is an effective way to minimize the conflict between company goals and division goals that arise using ROI. 

Rather than maximizing ROI, division managers focus on increasing RI. 

Managers are more likely to accept investment proposals that have a return greater than the company’s minimum required rate of return, regardless of the impact on the division’s ROI.

The downside of residual income is that it does not provide an efficient means for comparing divisions. 

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing