Residual income, often referred to as residual return, is the net income that a subsidiary or division of an organization generates after being charged a percentage return for the book value of the net assets or resources under its control. This approach ensures that the subsidiary or division maximizes its profits after accounting for the use of assets.
Historical Context
The concept of residual income emerged as businesses sought more accurate ways to measure and evaluate the financial performance of their various units. Traditionally, performance was measured by Return on Investment (ROI) or Return on Capital Employed (ROCE). However, these methods sometimes failed to account for the cost of capital adequately. Residual income addressed this gap, providing a clearer picture of the true economic profit.
Types/Categories of Residual Income
- Corporate Residual Income: Used to assess the performance of subsidiaries or divisions within a large corporation.
- Investment Residual Income: Evaluated in the context of investment portfolios to determine the profitability after accounting for the cost of capital.
- Personal Residual Income: In personal finance, it refers to the income remaining after all personal debts and obligations are paid.
Key Events in the Development of Residual Income
- Adoption in the 1980s: Many large corporations began adopting residual income as a performance measure during the late 1980s and early 1990s.
- Integration with EVA: The evolution of Economic Value Added (EVA), developed by Stern Stewart & Co., closely aligned with the principles of residual income, leading to its wider acceptance.
Detailed Explanation and Calculation
Residual income is calculated using the following formula:
Where:
- NOPAT: Net operating profit after taxes.
- Capital Charge: The cost of capital times the book value of net assets.
Example Calculation
Consider a company with two divisions, Division X and Division Y, each contemplating a £1,000,000 investment:
| Division X (£) | Division Y (£) | |
|---|---|---|
| Proposed Investment | 1,000,000 | 1,000,000 |
| Profit before Interest and Tax | 200,000 | 100,000 |
| Cost of Capital | 15% | 15% |
| Division X (£) | Division Y (£) | |
|---|---|---|
| Profit before Interest and Tax | 200,000 | 100,000 |
| Cost of Capital Charge | 150,000 | 150,000 |
| Residual Income | 50,000 | (50,000) |
Importance and Applicability
- Performance Measurement: Residual income provides a more accurate measure of performance by considering the cost of capital.
- Decision Making: Helps managers make informed decisions about investments and project viability.
- Risk Adjustment: Different cost of capital percentages can be applied to account for varying levels of risk across divisions.
Considerations
- Cost of Capital: Must be accurately determined to reflect true costs.
- Economic Conditions: Changing interest rates and market conditions can affect residual income calculations.
- Intra-Company Comparisons: May require adjusting for different risk levels between divisions.
Related Terms
- Economic Value Added (EVA): A similar concept that measures a company’s financial performance based on residual income.
- Return on Capital Employed (ROCE): A traditional measure of performance that does not consider the cost of capital.
Comparisons
| Aspect | Residual Income | ROCE |
|---|---|---|
| Considers Cost of Capital | Yes | No |
| Focus | Economic profit | Accounting profit |
| Risk Adjustment | Yes (through different capital charges) | No |
Interesting Facts
- Many large corporations, including Coca-Cola and GE, have used residual income for internal performance measurement.
- Surveys indicate that despite its theoretical advantages, many managers still prefer ROCE due to its simplicity.
Inspirational Stories
Jack Welch, the former CEO of GE, famously used economic profit measures like residual income to drive performance across GE’s numerous business units, leading to significant value creation.
Famous Quotes
“Residual income allows us to gauge true value creation, beyond mere accounting profits.” - Unknown Finance Expert
Proverbs and Clichés
- “What gets measured gets managed.” – Peter Drucker
- “Profit is a measure; value is the goal.”
Expressions, Jargon, and Slang
- NOPAT: Net Operating Profit After Taxes
- Capital Charge: The cost associated with the capital employed in the business.
FAQs
How does residual income differ from EVA?
Why might managers prefer ROCE over residual income?
References
- Stern Stewart & Co., Economic Value Added.
- Brigham, E. F., & Ehrhardt, M. C. (2014). Financial Management: Theory & Practice.
- Drucker, P. F. (1954). The Practice of Management.
Summary
Residual income is a robust financial metric that offers a comprehensive measure of a division’s or subsidiary’s performance by accounting for the cost of capital. This method helps organizations make informed decisions, align investments with company strategy, and drive value creation. While it may be theoretically superior to traditional measures like ROCE, its complexity can be a barrier to widespread adoption. Nonetheless, its ability to provide a true picture of economic profit makes it an invaluable tool in modern financial management.
