Saturday, May 30, 2020

Residual Income - Meaning and Formula, Explained in Detail

Residual Income
Residual Income

Residual Income is a method under which Performance Evaluation can be done on the basis of profit remaining after meeting the cost of capital. Residual income formula shall be derived on the basis of subtraction of the cost of capital from controllable profit. Let's understand more in detail.

What is Residual Income

Residual Income represents "subtraction of cost of capital from the return", it means an organization earned controllable profit would subtract first the cost of capital of the organization and the remaining portion after such subtraction will be known as Residual Income. Residual Income method is beneficial for so many purposes out of which one is, it is beneficial for evaluating the performance of divisional managers.

Let's understand how this method is best for the organization:-

Suppose we have given investment decision for division X and Y, the residual income calculations are as follows:

Particulars Division X (in lakhs) Division Y(in Lakhs)
Proposed Investment 20 20
Controllable Contribution(a) 2 1.4
Cost of Capital(b) 1.6 1.6
Residual Income(a-b) 04 (.20)

The above calculation indicates that the residual income of division X will increase and division  Y will decrease if both managers will accept the project. Therefore Manager of Division X would invest while the manager of division Y would not. This action is best for the company as a whole.

Formula of Residual Income

Sr. No. Particular Amount
1 Net Controllable Operating Profit after Tax XXX
2 Less: Cost of Capital* XXX
Residual Income XXX

Cost of Capital = Capital Employed X % of Cost of Capital 
Capital Employed = Fixed Assets + Working Capital

Advantages of Residual Income

The residual Income method is beneficial to use in case of calculation of managerial performance. In this method, the return is subtracted from the cost of capital that means if managerial performance would be based on residual income then they feel encouraged to make more profit for the organization as in return they will get more bonus.

Disadvantages of Residual Income

Residual income facing disadvantages that in this method it is very difficult to compare the performance of a division with that of other divisions or companies of different sizes. For example, a big division will definitely earn a more residual income in comparison to a small division.

Example of Residual Income vs ROI

The following data pertain to two divisions X and Y of a local company given below:

Particular X Y
Profit 1,20,00,000 31,20,000
Investment 9,60,00,000 1,56,00,000

Cost of capital = 10%

Solution: This example shows that RI is subject to a size effect but ROI is not. The large size for the X Division(Which is more than 6 times that of the Y Division) overcomes its lower profitability, as measured by ROI. Thus, Residual Income is not a good way to compare divisions with different sizes of Divisions.

X Y Remark
ROI 12.5%
Y division has higher ROI
RI Rs.2400000
(1,20,00,000 -10% of 9,60,00,000)
(31,20,000- 10 % of 1,56,00,000)
X division has a higher RI

I hope this article really helps you. If you have still any doubt then you can ask through mail or can do comment here.residual income,what is residual income, formula of residual income

Written by - Pankaj Kumar

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